• Cost planning
• Cost Analysis
• Cost management Techniques
• Externally oriented Cost Management Techniques
• Relevant costs
• Short term decisions
• Risk and Uncertainty
• Linear programming – graphical method
• Linear programming the simplex method
• Multi Product CVP Analysis
• Pricing decisions and Pricing strategies
• Budgetary Control
• Performance Evaluation
• Measuring performance in divisionalised businesses
• Transfer pricing

Responsibility centres

The area of operations for which a manager is responsible might be called a responsibility centre. Within an organisation, there could be a hierarchy of responsibility centres.

A large organisation can be structured in one of two ways: functionally (all activities of a similar type within a company, such as production, sales, research, are under the control of the appropriate departmental head) or divisionally (split into divisions in accordance with the products or services made or provided).

A divisional structure will lead to decentralisation of the decision-making process and divisional managers may have the freedom to set selling prices, choose suppliers, make product mix and output decisions and so on.

 

Decentralisation or divisionaliation

Decentralisation seeks to overcome the problem of managing a large organisation by creating a structure based on several autonomous decision-making units.

Objectives

1. Ensure goal congruence
2. Increase motivation of management
3. Reduce head office bureaucracy
4. Provide better training for junior and middle management

Advantages of divisionalisation

1. Divisionalisation can improve the quality of decisions made and decisions should be taken more quickly.
2. The authority to act to improve performance should motivate divisional managers.
3. Divisional organisation frees top management from detailed involvement in day-to-day operations and allows them to devote more time to strategic planning.

The major disadvantage of decentralisation is the potential for dysfunctional decision making, i.e. where divisions make decisions in their own best interests, but which are not good from the company point of view.

The problem is overcome by introducing a suitable system of performance evaluation.

Performance evaluation 

Objectives

1. Promote goal congruence
2. Encourage initiative and motivation
3. Provide feedback to management
4. Encourage long-term rather than short term views

These objectives can only be achieved with the introduction of responsibility centres.

 

Responsibility accounting

Responsibility accounting is a system of accounting that segregates revenue and costs into areas of personal responsibility in order to monitor and assess the performance of each part of an organisation.

Dividing an organization into different areas or segments based on areas of responsibility is known as responsibility accounting.

It is usual in budgeting to apply the principles of responsibility accounting. In responsibility accounting, a specific manager is given the responsibility for a particular aspect of the budget, and within the budgetary control system, he or she is then made accountable for actual performance.

There are a number of types of responsibility accounting unit or responsibility centre that can be used within a system of responsibility accounting.

In the weakest form of decentralisation a system of cost centres might be used. As decentralisation becomes stronger, the responsibility accounting framework will be based around profit centres. In its strongest form investment centres are used.

Each cost centre, profit centre and investment centre should have its own budget, and its manager should receive regular budgetary control information relating to the centre, for control and performance measurement purposes.

Attributable costs and controllable costs

If the principle of controllability is applied, a manager should be made responsible and accountable only for the costs (and revenues) that the manager is in a position to control. In responsibility accounting, an attributable cost is a cost that can be specifically identified with a particular responsibility centre. No arbitrary apportionment is necessary to share the cost over a number of different responsibility centres. Most attributable costs will be controllable costs.

Controllable costs are generally assumed to be variable costs, and directly attributable fixed costs.

An item that is uncontrollable for one manager could be controllable by another. In responsibility accounting, it is important to identify areas of responsibility. Within a system of responsibility accounting, there should be cost centre managers accountable for these costs.

 

Cost centres

If a manager is responsible for a particular aspect of operating costs, the responsibility centre is a cost centre. The manager has no responsibility for earning revenues or for controlling the assets and liabilities of the centre.

A cost centre could be large or small, such as an entire department or the activities associated with a single item of equipment.

Functional departments such as production, personnel and marketing might be treated as cost centres and made responsible for their costs.

A performance report for a cost centre might look like this:

Two important points to note about this report are as follows:

1. The report should include only controllable costs and, there should be a clear distinction in the report between controllable costs and uncontrollable costs.
2. The actual costs are compared with a budget that has been flexed to the actual activity level achieved.

 

Revenue centres

The manager of a revenue centre is responsible only for raising revenue but has no responsibility for forecasting or controlling costs. Such responsibility would pass to a more senior manager to whom the revenue centre manager reports.

Revenue centres are often used for control purposes in not-for-profit organisations such as charities.

Profit centres

A profit centre is a part of a business accountable for both costs and revenues. If a manager is responsible for revenue as well as costs, the responsibility centre is a profit centre.

A profit centre’s performance report, in the same way as that for a cost centre, would identify separately the controllable and non-controllable costs. A profit centre performance report might look like this:

The budget for the sales revenue and variable cost of sales will be flexed according to the activity level achieved and the variances could be analysed in further detail for the profit centre manager.

Notice that three different ‘profit levels’ are highlighted in the report.

1. Contribution, which is within the control of the profit centre manager.
2. Directly attributable gross profit, which is also within the manager’s control
3. Net profit, which is after charging certain uncontrollable costs and which is therefore not controllable by the profit centre manager.

*There could be several cost centres within a profit centre, with the cost centre managers responsible for the costs of their particular area of operations, and the profit centre manager responsible for the profitability of the entire operation.

 

Investment centres

An Investment Centre is a ‘Profit centre with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment’. If a manager is responsible for investment decisions as well as for revenues and costs, the responsibility centre is an investment centre.

*There could be several profit centres within an investment centre.

Return on investment (ROI)

Return on investment (ROI) is usually used to monitor the performance of an investment centre.

Return on investment (ROI) is generally regarded as the key performance measure. The main reason for its widespread use is that it ties in directly with the accounting process, and is identifiable from the statement of profit or loss and statement of financial position.

Return On Investment (ROI) or Return On Capital Employed (ROCE) shows how much profit has been made in relation to the amount of capital invested and is calculated as:

PBIT          x 100

Capital employed

• Profit is usually taken after depreciation but before interest and tax.
• Capital employed is total assets less current liabilities or total equity plus long term debt. Use net assets if capital employed is not given.

There is no generally agreed method of calculating ROI and it can have behavioural implications and lead to dysfunctional decision making when used as a guide to investment decisions. It focuses attention on short-run performance, whereas investment decisions should be evaluated over their full life.

Advantages

1. Widely used and accepted.
2. As a relative measure it enables comparisons to be made with divisions or companies of different sizes.
3. It can be broken down into secondary ratios for more detailed analysis.

Disadvantages

1. May lead to dysfunctional decision making.
2. Different accounting policies can confuse comparisons.
3. ROCE increases with age of asset if NBVs are used, thus giving managers an incentive to hang on to possibly inefficient, obsolescent.

 

ROI and decision-making

If investment centre performance is judged by ROI, managers of investment centres will probably decide to undertake new capital investments only if these new investments are likely to increase the ROI of their centre.

ROI should not be used to guide investment decisions, but there is a difficult motivational problem. If management performance is measured in terms of ROI, any decisions which benefit the company in the long term but which reduce the ROI in the immediate short term would reflect badly on the manager’s reported performance. In other words, good investment decisions would make a manager’s performance seem worse than if the wrong investment decision were taken instead.

Residual income (RI)

Residual Income (RI) is ‘Profit minus a charge for capital employed in the period’

Residual income (RI) can also be used to measure the performance of investment centres.  However, it has a number of weaknesses that make it less preferable than ROI as a performance measure.

RI can sometimes give results that avoid the behavioural problem of dysfunctionality. Its weakness is that it does not facilitate comparisons between investment centres, nor does it relate the size of a centre’s income to the size of the investment.

 

Calculating RI

An alternative way of measuring the performance of an investment centre, instead of using ROI, is residual income (RI). Residual income is a measure of the centre’s profits after deducting a notional or imputed interest cost.

• The centre’s profit is after deducting depreciation on capital equipment.
• Notional interest on capital = the capital employed in the division multiplied by a notional cost of capital or interest rate.

Advantages

1. It reduces ROCE’s problem of rejecting projects with a ROCE in excess of the company’s target, but lower than the division’s current ROCE.
2. The cost of financing a division is brought home to divisional managers.

Disadvantages

1. Does not facilitate comparisons between divisions.
2. Does not relate the size of a division’s profit to the assets employed in order to obtain that profit.

 

RI versus ROI: marginally profitable investments

Residual income will increase if a new investment is undertaken which earns a profit in excess of the imputed interest charge on the value of the asset acquired. Residual income will go up even if the investment only just exceeds the imputed interest charge, and this means that ‘marginally profitable’ investments are likely to be undertaken by the investment centre manager.

In contrast, when a manager is judged by ROI, a marginally profitable investment would be less likely to be undertaken because it would reduce the average ROI earned by the centre as a whole.

Economic value added (EVA)

Economic value added (EVA) is a measure of performance similar to residual income, except the profit figure used is the ECONOMIC profit and the capital employed figure used is the ECONOMIC capital employed.

The basic concept of EVA is that the performance of a company as a whole, or of investment centres within a company, should be measured in terms of the value that has been added to the business during the period. It is a measure of performance that is directly linked to the creation of shareholder wealth.

In order to add to its economic value, a business must make an economic profit in excess of the cost of the capital that has been invested to earn that profit.

 

Calculating EVA

EVA Summary:

PAT is adjusted to give the Net Operating Profit after tax (NOPAT)                             XX

Less: The economic value of the capital employed x cost of capital                             (XX)

 

Measuring EVA

The difficulties in applying EVA in practice arise from the problem of establishing the economic profit in a period, and the economic value of capital employed. These values are estimated by making adjustments to accounting profits and accounting capital employed.

• Accounting profits are based on the accruals concept of accounting, whereas NOPAT for EVA is based on cash flow profits. Adjustments have to be made to convert from an accruals basis to a cash flow basis.
• Depreciation of non-current assets is a charge in calculating EVA as well as accounting profit. Economic depreciation is the fall in the economic value of an asset during the period.
  • It might be assumed that the accounting charge for depreciation is a good approximation of the economic cost of depreciation, in which case no adjustment to accounting profit is necessary.
  • Alternatively, it might be assumed that the economic value of the assets are their net replacement cost, in which case economic depreciation will be based on replacement cost. An adjustment to accounting profit should then be made for the amount by which economic depreciation exceeds the accounting charge for depreciation.
• Similarly, an adjustment might be necessary for intangible non-current assets such as goodwill.
• Where a company had made a provision for doubtful debts, this should be reversed. Any adjustment in the income for an increase or decrease in the provision for doubtful debts should be reversed, and NOPAT increased or reduced accordingly.
• Spending by the company on development costs should not be charged in full against profit in the year the expenditure occurs. Instead, it should be capitalised because it has added to the economic value of capital employed, and it should then be amortised over an appropriate number of years. In practice, the adjustment can be made by:
  • increasing NOPAT by the net increase in capitalised development costs, and
  • increasing the economic value of capital employed by the same amount.
• All leases should be capitalised. Finance leases will have been capitalised already, but operating leases should be capitalised too, and the economic value of capital employed increased to include the current value of operating leases.

Using EVA

Economic value added can be used to:

1. set targets for performance for investment centres (divisions) and the company as a whole.
2. measure actual performance.
3. plan and make decisions on the basis of how the decision will affect EVA.

 

Advantages of EVA

The advantages of EVA are as follows:

1. It is a performance measure that attempts to put a figure to the increase (or decrease) that should have arisen during a period from the operations of a company or individual divisions within a company.
2. Like accounting return and residual income, it can be measured for each financial reporting period.
3. It is easily understood by non-accountants.
4. It is based on economic profit and economic values of assets, not accounting profits and asset values.

 

EVA versus RI

EVA and RI are similar because both result in an absolute figure which is calculated by subtracting an imputed interest charge from the profit earned by the investment centre. However, there are differences as follows:

1. The profit figures are calculated differently. EVA is based on an ‘economic profit’ which is derived by making a series of adjustments to the accounting profit.
2. The notional capital charges use different bases for net assets. The replacement cost of net assets is usually used in the calculation of EVA.

• Cost planning
• Cost Analysis
• Cost management Techniques
• Externally oriented Cost Management Techniques
• Relevant costs
• Short term decisions
• Risk and Uncertainty
• Linear programming – graphical method
• Linear programming the simplex method
• Multi Product CVP Analysis
• Pricing decisions and Pricing strategies
• Budgetary Control
• Performance Evaluation
• Measuring performance in divisionalised businesses
• Transfer pricing

Financial performance indicators (FPIs)

An organisation should have certain targets for achievement. Targets can be expressed in terms of key metrics. The term ‘metric’ is now in common use within the context of measurement of performance. It is a basis for analysing performance (both budgeted and actual).

A budget should not be approved by senior management unless budgeted performance is satisfactory, as measured by the key metrics. Actual performance should then be assessed in comparison with the targets.  The term ‘key performance indicators’ might be used.

Financial performance indicators analyse:

1. Profitability
2. Liquidity
3. Risk

 

Profitability

A company should of course be profitable, and there are obvious checks on profitability.

The primary objective of a company is to maximise profitability. Profitability ratios can be used to monitor the achievement of this objective.

A key metric for profitability might be the profit/sales ratio (profit margin), or the contribution/sales ratio (contribution margin).

Gross profit margin

A high gross profit margin is desirable. It indicates that either sales prices are high or that production costs are being kept well under control.

Gross profit margin =  Gross profit  x100

                                Turnover

 

Net profit margin

A high net profit margin is desirable. It indicates that either sales prices are high or that all costs are being kept well under control.

Net profit margin =   Net profit x 100

                                 Turnover

 

Return on capital employed (ROCE)

This is a key measure of profitability. It is the net profit as a percentage of the capital employed. ROCE is sometimes calculated using operating profit (profit before finance charges and tax) instead of net profit. If net profit is not given in the question, use operating profit instead.

A high ROCE is desirable. An increase in ROCE could be achieved by:

• Increasing net profit, e.g. through an increase in sales price or through better control of costs.
• Reducing capital employed, e.g. through the repayment of long-term debt.

ROCE = Net profit x 100

    Capital employed

*Where capital employed = total assets less current liabilities or total equity plus long term debt.

The ROCE can be understood further by calculating the net profit margin and the asset turnover:

ROCE = net profit margin × asset turnover

Asset turnover

This is the turnover divided by the capital employed. A high asset turnover is desirable. An increase in the asset turnover could be achieved by:

• Increasing turnover, e.g. through the launch of new products or a successful advertising campaign.
• Reducing capital employed, e.g. through the repayment of long-term debt.

There is a direct relationship between the key profitability indicators (ROCE, the asset turnover and the profit/sales percentage). Profit margin and asset turnover together explain the ROCE, and if the ROCE is the primary profitability ratio, these other two are the secondary ratios. The relationship between the three ratios is as follows:

Profit margin     x                             Asset turnover                  =                             ROCE

PBIT                       x                                   Sales                                =                             PBIT

Sales                                                     Capital employed                                            Capital employed

 

Liquidity

A company needs liquid assets so that it can meet its debts when they fall due.

Liquidity is the amount of cash a company can obtain quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).

Liquid funds include:

• Cash
• Short-term investments for which there is a ready market, such as investments in shares of other companies
• Fixed-term deposits with a bank or building society, for example six-month deposits with a bank
• Trade receivables
• Bills of exchange receivable

In summary, liquid assets are current asset items that will or could soon be converted into cash, and cash itself. Two common definitions of liquid assets are all current assets or all current assets with the exception of inventories.

Current ratio

Liquidity comes from current assets, including cash. The need for liquidity comes from the need to settle current liabilities.

The current ratio is simply a ratio that compares short-term sources of cash (current assets) with short-term needs for cash (current liabilities).

Current assets

Current liabilities

As a very rough guide, an ‘ideal’ current ratio may be 1.5:1 or 2:1. A ratio of less than 1:1 could indicate liquidity problems, because the entity might be unable to obtain cash from normal business activities to settle its current liabilities.

 

Quick ratio (acid test ratio)

Inventory turnover could be very slow. In such cases, inventory is not a liquid asset and will not generate cash within a fairly short period of time in order to pay off the current obligations due in the next month or so.

The quick ratio or acid test ratio is similar to the current ratio, but it excludes inventory from current assets.

Current assets (less) Inventory

Current liabilities

By eliminating inventory, the quick ratio measures a worst-case-scenario. It can be used to ask the question: Does the entity appear to have sufficient cash and near cash assets (including receivables) to provide the money to settle all current liabilities on time?

‘Ideally’ the quick ratio should be about 0.8:1 to 1.0:1.

Inventory turnover

Inventory turnover is a measure of how quickly an entity uses its inventory. It is also a measure of how slowly an entity uses its inventory, and how long items are held in inventory before they are eventually used or sold.

Inventory turnover may be measured as ‘x times a year’.

Cost of Sales

Average Inventory

A low turnover indicates inefficient use of resources. The slower inventory turnover, the greater the risk of obsolescence.

Inventory turnover may also be measured as an average number of days, rather than as ‘x times a year’.

Average Inventory x 365

Cost of Sales

This calculates the number of days a company takes to sell its average holding of inventory.

Separate turnover ratios could be calculated for:

• raw materials
• work in progress (the production cycle), and
• finished goods

 

Receivables turnover

It is sometimes called ‘debtor days’ or ‘days sales outstanding’. The receivables turnover ratio is usually measured in days. It is the average time that it takes an entity to collect amounts due from customers.

Average Trade Receivables x 365

Credit Sales

The ratio should ideally use credit sales, but the financial statements do not provide an analysis of sales into cash sales and credit sales. Therefore, total sales must normally be used, and this may produce an unrealistic ratio.

A change in the ratio from one year to the next may be due to:

• A change in settlement terms for credit customers, to encourage new business
• the introduction of debt factoring, which will reduce the average receivables collection period
• exceptional factors, such as one large new customer being offered extended credit.

Payables payment period

It is the average payment period to suppliers. It is normally measured in days.

Average Trade Payables x 365

Credit Purchases

The ratio should ideally use purchases on credit. However, this figure is not available from the financial statements, and the figure for the annual cost of sales should be used instead.

 

Risk

In addition to managing profitability and liquidity it is also important for a company to manage its risk. A company finances its net assets with a combination of equity and reserves and long-term debt. An entity is ‘high geared’ when a large proportion of its long-term capital is in the form of debt. High financial gearing is seen as a high-risk strategy.

‘Gearing’ examines the financing structure of a business and indicates to shareholders the level of financial risk to which the company is exposed because of its long-term capital structure.

These ratios, and changes in the ratios over time, can help them to assess the credit risk in their investment.

 

Gearing ratio

The gearing ratio (or leverage ratio) is usually calculated as follows:

Debt or    Debt x 100

Equity    Equity + Debt

Debt = Loans + Preference shares 

Equity = Equity share capital + reserves + non-controlling interest

Notes on financial gearing

• A highly geared company, with a substantial proportion of its capital in the form of debt, is seen by investors as ‘more risky’.
• High gearing is acceptable if it is accompanied by stable annual profits (PBIT) or increasing profits.
• A highly-geared company may find it more difficult to raise additional debt capital.

Interest cover

The interest cover ratio measures the ability of a company to meet its obligations to pay interest on debt (out of its profits).

The ratio therefore compares profit before interest and tax with the annual interest charges.

Profit before interest

Interest

A high interest cover suggests a sensible financing structure.

An interest cover of 2 times or less generally indicates that the company might have difficulty paying its interest if there is a fall in its profits.

 

Dividend cover

The dividend cover ratio measures the earnings of a company relative to the size of its dividend payments.

EPS/Net Profit

Net dividend per share

A decrease in the dividend cover indicates that the company is facing an increased risk of not being able to make its dividend payments to shareholders.

 

Non-financial performance indicators (NFPIs)

Changes in cost structures, the competitive environment and the manufacturing environment have led to an increased use of non-financial performance indicators (NFPIs).

As well as evaluating performance using financial performance indicators, companies can use non- financial indicators. NFPIs can usefully be applied to employees and product/service quality.

Non-Financial Performance Indicators (NFPIS) – are ‘measures of performance based on non-financial information that may originate in, and be used by, operating departments to monitor and control their activities without any accounting input’.

As with any performance indicator, an NFPI has to be viewed in some context in order to be most meaningful. A good control report will express indicators in terms of a deviation from plan, relative to an industry benchmark or as part of a trend analysis covering comparable earlier periods. 

Further, it is best to consider performance indicators as part of a package giving a multidimensional impression of how the organisation is performing.

One of the many criticisms of traditional accounting performance measurement systems is that they do not measure the skills, morale and training of the workforce, which can be as valuable to an organisation as its tangible assets.

The Balanced scorecard

The balanced scorecard is an approach to performance measurement and control emphasises the need to provide management with a set of information which covers all relevant areas of performance.

The balanced scorecard approach is an ‘Approach to the provision of information to management to assist strategic policy formulation and achievement. It emphasises the need to provide the user with a set of information which addresses all relevant areas of performance in an objective and unbiased fashion. The information provided may include both financial and non-financial elements, and cover areas such as profitability, customer satisfaction, internal efficiency and innovation.’

The traditional performance measure for a business is of course financial, but one problem is that the financial measures relate to the past. The Balanced Scorecard incorporates non-financial measures of the drivers of future performance as well as financial measures of past performance.

The balanced scorecard focuses on four different perspectives, as follows:

1. Customer – what is it about us that new and existing customers value?
2. Internal – what processes must we excel at to achieve our financial and customer objectives?
3. Innovation and learning – how can we continue to improve and create future value?
4. Financial – how do we create value for our shareholders?

The scorecard is ‘balanced’ in the sense that managers are required to think in terms of all four perspectives, to prevent improvements being made in one area at the expense of another.

Within each of these perspectives a company should seek to identify a series of goals and measures.

The important features of balanced scorecard approach are:

1. It looks at both internal and external matters concerning the organisation.
2. It is related to the key elements of a company’s strategy.
3. Financial and non-financial measures are linked together.

Benefits of the balanced scorecard:

1. It focuses on factors, including non-financial ones, which will enable a company to succeed in the long-term.
2. It provides external as well as internal information.

Problems with the balanced scorecard:

1. The selection of measures can be difficult.
2. Information overload due to the large number of measures that may be chosen.
3. Conflict between measures.

Benchmarking

Analysing performance by a single comparison of data (e.g.: current year vs prior year) can be difficult. Benchmarking is a type of comparison exercise through which an organisation attempts to improve performance. The idea is to seek the best available performance against which the organisation can monitor its own performance.

‘Benchmarking is the establishment, through data gathering, of targets and comparators, through whose use relative levels of performance (and particularly underperformance) can be identified. By the adoption of identified best practices it is hoped that performance will improve.’

Benchmarking is an attempt to identify best practices and to achieve improved performance by comparison of operations.

Financial information about competitors is easier to acquire than non-financial information. Information about processes (how an organisation deals with customers or suppliers) is more difficult to find. Such information can be obtained through the following channels:

1. In intra-group benchmarking, groups of companies in the same industry agree to pool data on their processes. The processes are benchmarked against each other and an ‘improvement taskforce’ is established to undertake strategic benchmarking to identify and transfer ‘best practice’ to all members of the group.
2. In inter-industry benchmarking, a non-competing business with similar processes is identified and asked to participate in a functional benchmarking exercise. The participants in the scheme are able to benefit from the experience of the other and establish ‘best practice’ in their common business processes.

The reasons for benchmarking may be summarised as:

1. To receive an alarm call about the need for change
2. Learning from others in order to improve performance
3. Gaining a competitive edge (in the private sector)
4. Improving services (in the public sector)

 

Approaches to Benchmarking

Three distinct approaches to benchmarking are:

1. Metric benchmarking – The practise of comparing appropriate metrics to identify possible areas for improvement. For example, IT investment as a percentage of total assets may be compared across different departments within the same company to identify areas of the company where additional investment is required.
2. Process benchmarking – The practise of comparing processes with a partner as part of an improvement process. For example, a distributor of personal computers may analyse a competitor’s supply chain function in the hope of identifying successful elements of the process that it can use to its advantage.
3. Diagnostic benchmarking – The practise of reviewing the processes of a business to identify those which indicate a problem and offer a potential for improvement. For example, a company may critically assess each element of the value chain and conclude that there is potential for improvement within the marketing and sales function.

Types of benchmarking

1. Internal benchmarking – With internal benchmarking, other units or departments in the same organisation are used as the benchmark. This might be possible if the organisation is large and divided into a number of similar regional divisions. Internal benchmarking is also widely used within government.
2. Competitive benchmarking – With competitive benchmarking, the most successful competitors are used as the benchmark. Competitors are unlikely to provide willingly any information for comparison, but it might be possible to observe competitor performance.
3. Functional benchmarking – In functional benchmarking, comparisons are made with a similar function (for example selling, order handling, despatch) in other organisations that are not direct competitors.
4. Strategic benchmarking – Strategic benchmarking is a form of competitive benchmarking aimed at reaching decisions for strategic action and organisational change. Companies in the same industry might agree to join a collaborative benchmarking process, managed by an independent third party such as a trade organisation. With this type of benchmarking, each company in the scheme submits data about their performance to the scheme organiser. The organiser calculates average performance figures for the industry as a whole from the data supplied. Each participant in the scheme is then supplied with the industry average data, which it can use to assess its own performance.

 

Benchmarking – the Disadvantages

There a number of potential disadvantages that businesses should consider prior to performing a benchmarking exercise.

1. Businesses may experience difficulties in deciding which activities to benchmark.
2. Businesses may find it difficult to identify the ‘best in class’ for each activity.
3. It is often difficult to persuade other organisations to share information.
4. Successful practices in one organisation may not transfer successfully to another.
5. There is a risk of drawing incorrect conclusions from inappropriate comparisons.

 

The building block model – Performance evaluation in Service industry

The building block model is based on three building blocks:

1. Dimensions
2. Standards
3. Rewards

 

Dimensions

Dimensions are the goals for the business and suitable measures must be developed to measure each performance dimension. Dimensions are the areas that yield specific performance metrics for a company.

The six dimensions in the building block model can be split into two categories:

1. downstream results (competitive and financial performance) and
2. upstream determinants (quality of service, flexibility, resource utilisation and innovation) of those results.

The last four are the drivers of the top two.

Standards

Standards are the targets set for the metrics chosen from the dimensions. To ensure success it is vital that employees view standards as achievable, fair and take ownership of them.

Rewards

Rewards are the motivators for the employees to work towards the standards set. The reward system should be clearly understood by the staff and ensure their motivation. The rewards should be related to areas of responsibility that the staff member controls in order to achieve that motivation.

• Cost planning
• Cost Analysis
• Cost management Techniques
• Externally oriented Cost Management Techniques
• Relevant costs
• Short term decisions
• Risk and Uncertainty
• Linear programming – graphical method
• Linear programming the simplex method
• Multi Product CVP Analysis
• Pricing decisions and Pricing strategies
• Budgetary Control
• Performance Evaluation
• Measuring performance in divisionalised businesses
• Transfer pricing

Budgetary Control

Budgetary control is carried out via a MASTER BUDGET devolved to responsibility centres, allowing continuous monitoring of actual results versus budget. These budget and budgetary control notes are prepared by mindmaplab team and covering budgetary control system, meaning, definition, the types of budgetary control, the methods of budget monitoring and control with examples. These cost management budgetary control notes includes budgeting and budgetary control questions and answers with pdf notes. We have also prepared the Budgetary control pdf version download.

Flexible budgets and Budgetary control

Flexible budgets

A fixed budget contains information on costs and revenues for one level of activity. Whereas, a flexible budget shows the same information, but for a number of different levels of activity. Flexible budgets are useful for both planning purposes and control purposes.

A flexible budget is a budget which, by recognising different cost behaviour patterns, is designed to change as volume of activity changes.

Flexible budgets are prepared using marginal costing and so mixed costs must be split into their fixed and variable components (possibly using the high/low method).

Flexible budgets should be used to show what cost and revenues should have been for the actual level of activity. Differences between the flexible budget figures and actual results are variances.

Flexible budgets may be prepared in order to plan for variations in the level of activity above or below the level set in the fixed budget.

The BUDGET COST ALLOWANCE/FLEXIBLE BUDGET is the budgeted cost ascribed to the level of activity achieved in a budget centre in a control period. It comprises variable costs in direct proportion to volume achieved and fixed costs as a proportion of the annual budget.

Flexible budgets are essential for control purposes.  They represent the expected revenues, costs and profits for the actual units produced and sold and are then compared to actual results to determine any differences (or variances).

Care must be taken to distinguish between controllable costs and uncontrollable costs in variance reporting

 

Flexible budgets using ABC data

Instead of flexing budgets according to the number of units produced or sold, in an ABC environment it is possible to use more meaningful bases for flexing the budget. The budget cost allowance for each activity can be determined according to the number of cost drivers.

 

The link between standard costing and budget flexing

The calculation of standard cost variances and the use of a flexed budget to control costs and revenues are very similar in concept.

However, there are differences between the two techniques:

1. Standard costing variance analysis is more detailed e.g. the total cost variance is analysed further to determine how much of the total variance is caused by a difference in the price paid (e.g. the material price variance) and how much is caused by the usage of material being different from the standard. In flexible budget comparisons only total cost variances are derived.
2. For a standard costing system to operate, it is necessary to determine a standard unit cost for all items of output. All that is required to operate a flexible budgeting system is an understanding of the cost behaviour patterns and a measure of activity to use to flex the budget cost allowance for each cost element.

 

Budgetary control

Budgetary control is carried out via a MASTER BUDGET devolved to responsibility centres, allowing continuous monitoring of actual results versus budget, either to secure by individual action the budget objectives or to provide a basis for budget revision’.

Budgetary control is based around a system of budget centres. Each budget centre will have its own budget and a manager will be responsible for managing the budget centre and ensuring that the budget is met.

Budget Centre – A budget centre is ‘A section of an entity for which control may be exercised through budgets prepared’.

Budgetary control and budget centres are therefore part of the overall system of responsibility accounting within an organisation.

The correct approach to budgetary control is to compare actual results with a budget which has been flexed to the actual activity level achieved.

 

Feedback and Feed Forward controls

Feedback Control

Feedback is the comparison of actual results against expected results and if there is a significant difference, then it is investigated and if possible and desirable it is corrected. This is the most common type of control system.

Feedback control is the measurement of differences between planned outputs and actual outputs achieved, and the modification of subsequent action and/or plans to achieve future required results.

Corrective action that brings actual performance closer to the target or plan is called negative feedback. With negative feedback, the control action is intended to bring actual performance back into line with the budget. For example, if actual costs are higher than budget, control action might be taken to cut costs.

Corrective action that increases the difference between actual performance and the target or plan is called positive feedback. With positive feedback, control action would be intended to increase the differences between the budget and actual results. For example, if actual sales are higher than budget, control action might be taken to make this situation continue.

*Budgetary control systems are feedback control systems.

 

Feedforward Control

Feedforward is the comparison of the results that are currently expected (budgeted) in the light of the latest information and the desired results (forecast). If there is a difference, then it is investigated and corrected.

Feedback happens after the event and discovers that something has gone wrong (or right). Whereas, Feedforward is more proactive and aims to anticipate problems and prevent them from occurring.

Feedforward control a feedforward control system operates by comparing budgeted results against a forecast. Control action is triggered by differences between budgeted and forecast results.

Whereas feedback is based on a comparison of historical actual results with the budget for the period to date, feed-forward looks ahead and compares:

• the target or objectives for the period, and
• what actual results are now forecast.

Target costing is an example of feed-forward control.

 

Behavioural implications of budgeting

Although the principal purpose of a budgetary control system is to assist in planning and control, it can also have an effect on the behaviour of those directly affected by the budget.

The purpose of a budgetary control system is to assist management in planning and controlling the resources of their organisation by providing appropriate control information. The information will only be valuable, however, if it is interpreted correctly and used purposefully by managers and employees.

The correct use of control information therefore depends not only on the content of the information itself, but also on the behaviour of its recipients. A number of behavioural problems can arise:

1. The managers who set the budget or standards are often not the managers who are then made responsible for achieving budget targets.
2. The goals of the organisation as a whole, as expressed in a budget, may not coincide with the personal aspirations of individual managers.

The management accountant should therefore try to ensure that employees have positive attitudes towards setting budgets, implementing budgets (that is, putting the organisation’s plans into practice) and feedback of results (control information).

 

Participation in budgeting

It has been argued that participation in the budgeting process will improve motivation and so will improve the quality of budget decisions and the efforts of individuals to achieve their budget targets.

There are basically two ways in which a budget can be set:

1. top down (imposed budget)
2. bottom up (participatory budget)

 

Imposed style – Top down

An imposed/top-down budget is ‘A budget allowance which is set without permitting the ultimate budget holder to have the opportunity to participate in the budgeting process.

In this approach to budgeting, top management prepare a budget with little or no input from operating personnel, which is then imposed upon the employees who have to work to the budgeted figures.

The times when imposed budgets are effective:

1. In newly formed organisations
2. In very small businesses
3. During periods of economic hardship
4. When operational managers lack budgeting skills
5. When the organisation’s different units require precise co-ordination

Advantages of imposed style

There are a number of reasons why it might be preferable for managers not to be involved in setting their own budgets:

1. Involving managers in the setting of budgets is more time consuming than if senior managers simply imposed the budgets.
2. Managers may not have the skills or motivation to participate usefully in the budgeting process.
3. Managers may build budgetary slack or bias into the budget in order to make the budget easy to achieve and themselves look good.

Disadvantages of imposed style

1. The feeling of team spirit may disappear.
2. The acceptance of organisational goals and objectives could be limited.
3. The feeling of the budget as a punitive device could arise.
4. Lower-level management initiative may be stifled.

 

Participative Budgets – Bottom up

Participative/bottom up budgeting is ‘A budgeting system in which all budget holders are given the opportunity to participate in setting their own budgets’.

In this approach to budgeting, budgets are developed by lower-level managers who then submit the budgets to their superiors. The budgets are based on the lower-level managers’ perceptions of what is achievable and the associated necessary resources.

Advantages of participative budgets

1. The morale of the management is improved. Managers feel like their opinion is listened to, that their opinion is valuable.
2. The lower level managers will have a more detailed knowledge of their particular part of the business than senior managers and thus will be able to produce more realistic budgets.

Disadvantages of participative budgets

1. They consume more time.
2. They may cause managers to introduce budgetary slack and budget bias.
3. They can support ’empire building’ by subordinates.
4. An earlier start to the budgeting process could be required

If managers are involved in preparing a budget, poor attitudes or hostile behaviour towards the budgetary control system can begin at the planning stage:

1. Managers may complain that they are too busy to spend much time on budgeting.
2. They may build ‘slack’ into their expenditure estimates.
3. They may argue that formalising a budget plan on paper is too restricting and that managers should be allowed flexibility in the decisions they take.

 

Negotiated style of budgeting

A negotiated budget is a ‘Budget in which budget allowances are set largely on the basis of negotiations between budget holders and those to whom they report’.

At the two extremes, budgets can be dictated from above or simply emerge from below but, in practice, different levels of management often agree budgets by a process of negotiation.

Final budgets are therefore most likely to lie between what top management would really like and what junior managers believe is feasible. The budgeting process is hence a bargaining process and it is this bargaining which is of vital importance, determining whether the budget is an effective management tool or simply a clerical device.

 

Budget slack

Budget slack is the ‘Intentional overestimation of expenses and/or underestimation of revenues during the budget setting’.

Budget slack occurs when managers deliberately underestimate sales or overestimate costs to avoid being blamed for future poor results.

 

The use of budgets as targets

Once decided, budgets become targets. As targets, they can motivate managers to achieve a high level of performance:

• There is likely to be a demotivating effect where an ideal standard of performance is set.
• A low standard of efficiency is also demotivating,
• A budgeted level of attainment could be ‘normal’: that is, the same as the level that has been achieved in the past.

Budgets which are set for motivational purposes need to be stated in terms of aspirations rather than expectations, budgets for planning and decision purposes need to be stated in terms of the best available estimate of expected actual performance. The solution might therefore be to have two budgets:

1. A budget for planning and decision-making based on reasonable expectations (expectations budget)
2. A second budget for motivational purposes, with more difficult targets of performance (that is, targets of an intermediate level of difficulty) (aspirations budget)

In certain situations, it is useful to prepare an expectations budget (for planning and decision-making purposes) and an aspirations budget (to act as a motivational tool).

 

Budgets and motivation

Budgets serve many purposes, but in some instances their purposes can conflict and have an effect on management behaviour. There are no ideal solutions to the conflicts caused by the operation of a budgetary control system. Management and the management accountant have to develop their own ways of dealing with them, taking into account their organisation, their business and the personalities involved.

How senior management can offer support:

1. Making sure that a system of responsibility accounting is adopted
2. Allowing managers to have a say in formulating their budgets
3. Offering incentives to managers who meet budget targets
4. Not regarding budgetary control information as a way of apportioning blame.

Budget centre managers should accept their responsibilities – In-house training courses could be held to encourage a collective, co-operative and positive attitude among managers.

Support from the management accountant

The management accountant can offer support in the following ways:

1. Explain the meaning of budgets and control reports.
2. Keep accounting jargon in these reports to a minimum.
3. Provide control information with a minimum of delay.
4. Make sure that actual costs are recorded accurately.

 

Beyond budgeting

The argument for abolishing budgets, referred to as ‘beyond budgeting’.

Beyond Budgeting is ‘the idea that companies need to move beyond budgeting because of the inherent flaws in budgeting especially when used to set incentive contracts. It is argued that a range of techniques, such as rolling forecasts and market-related targets, can take the place of traditional budgets.’

The two fundamental concepts of the BB approach are the use of adaptive management processes rather than fixed annual budgets and a move to a more decentralised way of managing the business with a culture of personal responsibility.

The Beyond Budgeting Round Table (BBRT), an independent research collaborative lists the following ten criticisms of budgeting:

1. Budgets are time-consuming and expensive.
2. Budgets provide poor value to users.
3. Budgets fail to focus on shareholder value.
4. Budgets are too rigid and prevent fast response.
5. Budgets protect rather than reduce costs.
6. Budgets stifle product and strategy innovation.
7. Budgets focus on sales targets rather than customer satisfaction.
8. Budgets are divorced from strategy.
9. Budgets reinforce a dependency culture.
10. Budgets lead to unethical behaviour.

Two fundamental concepts underlie the beyond budgeting (BB) approach.

1. Use adaptive management processes rather than the more rigid annual budget. Traditional annual plans tie managers to predetermined actions which are not responsive to current situations. Managers should instead be planning on a more adaptive, rolling basis, but with the focus on cash forecasting rather than purely on cost control. Performance is monitored against world-class benchmarks, competitors and previous periods.
2. Move towards devolved networks rather than centralised hierarchies. The emphasis is on encouraging a culture of personal responsibility by delegating decision making and performance accountability to line managers.

 

BB implementation

A BB implementation should incorporate the following six main principles:

1. The responsibilities of managers within an organisation should be clearly defined.
2. Managers should be given goals and targets which are based on key performance indicators and benchmarks. These targets should be linked to shareholder value.
3. Managers should be given a degree of freedom to make decisions. A BB organisation chart should be ‘flat’.
4. Responsibility for decisions that generate value should be placed with ‘front line teams’ in line with the concept of TQM.
5. Front line teams should be made responsible for relationships with customers, associate businesses and suppliers.
6. Information support systems should be transparent and align with the activities that managers are responsible for.

 

Rolling budgets

A rolling budget is a ‘budget continuously updated by adding a further accounting period (month or quarter) when the earliest accounting period has expired’.  Rolling budgets are also called ‘continuous budgets. Rolling budgets are for a fixed period, but this need not be a full financial year.

Suitable if:

1. accurate forecasts cannot be made. For example, in a fast-moving environment, or
2. for any area of business that needs tight control.

A typical rolling budget might be prepared as follows:

If rolling annual budgets are prepared quarterly, four rolling budgets will be prepared each year, each for a 12-month period. A new quarter is added at the end of the new budget period, to replace the current quarter just ending:

• One budget might cover the period 1 January – 31 December Year 1.
• The next rolling budget will cover 1 April Year 1 to 31 March Year 2.
• The next rolling budget will cover 1 July Year 1 to 30 June Year 2.
• The next quarterly rolling budget will cover 1 October Year 1 to 30

The reason for preparing rolling budgets is to deal with the problem of uncertainty in the budget, when greater accuracy and reliability are required.

Advantages of rolling budgets

1. They reduce uncertainty in budgeting.
2. They can be used for cash management.
3. They force managers to look ahead continuously.
4. When conditions are subject to change, comparing actual results with a rolling budget is more realistic than comparing actual results with a fixed annual budget.

Disadvantages of rolling budgets

1. Preparing new budgets regularly is time-consuming.
2. It can be difficult to communicate frequent budget changes.

 

Spreadsheets and budgeting

It is also true to say that budgets are a planning device designed to assist in the achievement of an organisation’s longer-term plans.

• There are likely to be a number of alterations made to the first draft of the budget to see the effects of such changes.
• The alteration of one value will cause many other values to alter.

The use of a spreadsheet allows these alterations to be made accurately and very quickly by the use of formulae. This is often referred to as ‘What If’ analysis.

A spreadsheet is a computer package which stores data in a matrix format where the intersection of each row and column is referred to as a cell. They are commonly used to assist in the budgeting process.

Advantages of spreadsheets

1. Large enough to include a large volume of information
2. Formulae and look up tables can be used so that if any figure is amended, all the figures will be immediately recalculated. This is very useful for carrying out sensitivity analysis.
3. The results can be printed out or distributed to other users electronically quickly and easily.
4. Most programs can also represent the results graphically e.g. balances can be shown in a bar chart.

Disadvantages of spreadsheets

1. Data can be accidentally changed (or deleted) without the user being aware of this occurring.
2. Educating staff to use spreadsheets / models and which areas /cells to use as inputs can be time consuming.
3. Version control issues can arise.
4. Errors in design, particularly in the use of formulae, can produce invalid output.

• Cost planning
• Cost Analysis
• Cost management Techniques
• Externally oriented Cost Management Techniques
• Relevant costs
• Short term decisions
• Risk and Uncertainty
• Linear programming – graphical method
• Linear programming the simplex method
• Multi Product CVP Analysis
• Pricing decisions and Pricing strategies
• Budgetary Control
• Performance Evaluation
• Measuring performance in divisionalised businesses
• Transfer pricing

Short-term decisions are decisions where the financial consequences occur soon after the decision is taken. For example, a short-term decision may result in an immediate increase in profit (additional net cash inflows), or an increase in annual profits and cash flows.

It is often assumed that marginal costs are relevant costs for the purpose of decision-making.

 

Limiting factor decisions

It is often assumed in budgeting that a company can produce as many units of its products (or services) as is necessary to meet the available sales demand. Sales demand is therefore normally the factor that sets a limit on the volume of production and sales in each period.

Sometimes, however, there could be a shortage of a key production resource, such as an item of direct materials, or skilled labor, or machine capacity. In these circumstances, the factor setting a limit to the volume of sales and profit in a particular period is the availability of the scarce resource, because sales are restricted by the amount that the company can produce.

Decision-making techniques for limiting factor situations are based on the following assumptions:

• The objective is to maximize profit and this is achieved by maximizing contribution;
• Marginal costs (variable costs) are the only relevant costs to consider in the model; and
• Fixed costs will be the same whatever decision is taken; therefore, fixed costs are not relevant to the decision.

 

Identifying limiting factors

Identify the limiting factor by calculating the budgeted availability of each resource and the amount of the resource that is needed to meet the available sales demand.

 

Maximizing profit when there is a single limiting factor

When there is just one limiting factor (other than sales demand), total profit will be maximized in a period by maximizing the total contribution earned with the available scarce resources.

The approach is to select products for manufacture and sale according to the contribution per unit of scarce resource in that product.

Step 1: Calculate the contribution per unit of each type of good produced.

Step 2: Identify the scarce resource.

Step 3: Calculate the amount of scarce resource used by each type of good produced.

Step 4: Divide the contribution earned by each good by the scarce resource used by that good to give the contribution per unit of scarce resource for that good.

Step 5: Rank the goods in order of the contribution per unit of scarce resource.

Step 6: Construct a production plan based on this ranking. The planned output and sales are decided by working down through the priority list until all the units of the limiting factor (scarce resource) have been used.

 

Make-or-buy decisions: outsourcing

A make-or-buy decision is a decision about:

• whether to make an item internally or to buy it from an external supplier, or
• whether to do some work with internal resources, or to contract it out to another organization such as a sub- contractor or an outsourcing organization.

The economic basis for the decision whether to make internally or whether to buy externally (outsource production) should be based on relevant costs. The preferred option from a financial viewpoint should be the one that has the lower relevant costs.

A financial assessment of a make-or-buy decision typically involves a comparison of:

• the costs that would be saved if the work is outsourced or sub-contracted, and
• the incremental costs that would be incurred by outsourcing the work.

 

Make-or-buy decisions with scarce resources

A different situation arises when an entity is operating at full capacity, and has the opportunity to outsource some production in order to overcome the restrictions on its output and sales. For example, a company might have a restriction, at least in the short-term, on machine capacity or on the availability of skilled labor. It can seek to overcome this problem by outsourcing some work to an external supplier who makes similar products and which has some spare machine time or labor capacity.

The decision is about which items to outsource, and which to retain in-house. The profit-maximizing decision is to outsource those items where the costs of outsourcing will be the least.

To identify the least-cost outsourcing arrangement, it is necessary to compare:

• the additional costs of outsourcing production of an item with
• the amount of the scarce resource that would be needed to make the item in-house.

Costs are minimized (and so profits are maximized) by outsourcing those items where the extra cost of outsourcing is the lowest per unit of scarce resource ‘saved’.

 

One-off contract decisions (Accept or reject an order decisions)

Management might have an opportunity to carry out a contract or job for a customer, where the job is ‘once only’ and will not be repeated in the future. The decision is therefore to decide whether to agree to do the job at the price offered by the customer, or to decide a selling price at which an incremental profit would be made.

If it is a one-off contract, rather than regular production work, it would be worthwhile undertaking the contract if the extra revenue from the contract is higher than the relevant costs of doing the work (including any opportunity costs).

The incremental profit from the one-off contract is the revenue that would be obtained minus the relevant costs.

 

Shutdown decisions

Part of a business, for example a department or a product, may appear to be unprofitable.  A shutdown decision is a decision about whether or not to shut down a part of the operations of a company. From a financial viewpoint, an operation should be shut down if the benefits of shutdown exceed the relevant costs.

The quantifiable cost or benefit of closure

The relevant cash flows associated with closure should be considered. For example:

• the lost contribution from the area that is being closed (= relevant cost of closure)
• savings in specific fixed costs from closure (= relevant benefit of closure) known penalties and other costs resulting from the closure, e.g. redundancy, compensation to customers (= relevant cost of closure)
• any known reorganisation costs (= relevant cost of closure)
• any known additional contribution from the alternative use for resources released (= relevant benefit of closure).

If the relevant benefits are greater than the relevant costs of closure then closure may occur. However, before a final decision is made the business should also consider the non-quantifiable factors.

Non-quantifiable costs and benefits of closure

Some of the costs and benefits discussed above may be non- quantifiable at the point of making the shut-down decision:

• penalties and other costs resulting from the closure (e.g. redundancy, compensation to customers) may not be known with certainty
• reorganisation costs may not be known with certainty
• additional contribution from the alternative use for resources released may not be known with certainty.

 

Joint product further processing decisions

Joint products are products manufactured from a common process. In some instances, a company might have a choice between:

• selling the joint product as soon as it is output from the common process, or
• processing the joint product further before selling it (at a higher price).

The financial assessment should compare:

• the revenue that will be obtained (less any selling costs) from selling the joint product as soon as it is output from the common process, and
• the revenue that will be obtained if the joint product is processed further, less the incremental costs of further processing and then selling the product.

Applying relevant costing, the costs of the common process are irrelevant to the decision, because these costs will be incurred anyway, whatever the decision. The decision should be to further process the joint product if the extra revenue from further processing exceeds the extra (relevant) costs of the further processing.

 

Minimum selling price decisions

The minimum pricing approach is useful in the situation of intense competition, surplus production capacity, clearance of old stocks, getting special orders and/or improving market share of the product. In these situations, the selling price is the lowest price that a company may sell its product at – usually the price will be the Total Relevant Costs of Manufacturing.

• Cost planning
• Cost Analysis
• Cost management Techniques
• Externally oriented Cost Management Techniques
• Relevant costs
• Short term decisions
• Risk and Uncertainty
• Linear programming – graphical method
• Linear programming the simplex method
• Multi Product CVP Analysis
• Pricing decisions and Pricing strategies
• Budgetary Control
• Performance Evaluation
• Measuring performance in divisionalised businesses
• Transfer pricing

Traditional vs modern manufacturing philosophy

Traditional manufacturing philosophy

Traditional manufacturing philosophy focuses on the need to continue to use valuable resources (such as manufacturing equipment) to their full capacity and to maximise the length of production runs.  The main features of the traditional approach to manufacturing are as follows:

1. Labour and manufacturing equipment are so valuable they should not be left idle.
2. Resulting inventory not needed should be stored (thus hiding inefficient and uneven production methods).
3. To increase efficiency and reduce production cost per unit, batch sizes and production runs should be as large as possible.
4. Concerned with balancing production run costs and inventory holding costs.

 

Modern manufacturing philosophy

The main features of the modern approach to manufacturing are as follows:

1. Smooth, steady production flow (throughput)
2. Flexibility, providing the customer with exactly what is wanted, exactly when it is wanted (making the organisation a more complex affair to manage), so as to achieve competitive advantage
3. Volume versus variety – greater variety in volumes required by customers.
4. Just-in-time – that is, little or no inventory.

 

Total Quality Management (TQM)

TQM is the general name given to programmes which seek to ensure that goods are produced and services supplied of the highest quality.

Quality management becomes total (total quality management (TQM)) when it is applied to everything a business does.

The management of quality is the process of:

1. Establishing standards of quality for a product or service
2. Establishing procedures or production methods that ought to ensure that these required standards of quality are met in a suitably high proportion of cases
3. Monitoring actual quality
4. Taking control action when actual quality falls below standard

There are two basic principles of TQM:

1. Get it right, first time: TQM considers that the costs of prevention are less than the costs of correction. One of the main aims of TQM is to achieve zero rejects and 100% quality.
2. Continuous improvement: A second basic principle of TQM is dissatisfaction with the status quo: the belief that it is always possible to improve and so the aim should be to ‘get it more right next time’.

 

Costs of quality

Failing to satisfy customers’ needs and expectations, or failing to do so right first time, has a cost.

Definition:

The COST OF QUALITY is ‘the difference between the actual cost of producing, selling and supporting products or services and the equivalent costs if there were no failures during production or usage’.

The cost of quality can be analysed into the following:

1. COST OF PREVENTION – ‘the costs incurred prior to or during production in order to prevent substandard or defective products or services from being produced’ for example Quality engineering and Training in quality control.
2. COST OF APPRAISAL – ‘costs incurred in order to ensure that outputs produced meet required quality standards’ for example Acceptance testing and Inspection of goods inwards.
3. COST OF INTERNAL FAILURE – ‘the costs arising from inadequate quality which are identified before the transfer of ownership from supplier to purchaser’ for example Failure analysis and Losses from failure of purchased items
4. COST OF EXTERNAL FAILURE – ‘the cost arising from inadequate quality discovered after the transfer of ownership from supplier to purchaser’ for example Administration of customer complaints section and Cost of repairing products returned from customers.

External failure costs are the costs of failing to deliver a quality product externally. The sum of internal failure costs, prevention and appraisal costs is the cost of failing to deliver a quality product externally.

Management accounting reports

Management accounting systems can help organisations achieve their quality goals by providing a variety of reports and measures that motivate and evaluate managerial efforts to improve quality – including financial and non-financial measures.

Traditionally, the management accounting systems focused on output, not quality.

 

Kaizen Costing

Kaizen costing aims to reduce current costs by using such tools as value analysis and functional analysis.

KAIZEN COSTING focuses on obtaining small incremental cost reductions during the production stage of the product life cycle. It is based on the idea of an ongoing process of reviewing how the business operates in order to identify and implement cost savings. Each individual action may result in a small cost saving, but these are incremental and can add up to a material saving.

The cultural requirements of Kaizen costing are that the whole workforce should be involved, as suggestions for improvements can come from anyone.

The previous year’s actual production cost serves as the cost base for the current year’s production cost. A reduction rate and reduction amount are set (Kaizen cost goals). Actual performance is compared to the Kaizen goals throughout the year and variances are monitored. At the end of the current year, the current actual cost becomes the cost base for the next year. New (lower) Kaizen goals are set and the whole process starts again.

 

How are Kaizen goals met?

1. Reduction of non-value-added activities and costs
2. Elimination of waste
3. Improvements in production cycle time

 

Just-in-time (JIT)

JIT is a pull-based system of production, pulling work through the system in response to customer demand. This means that goods are only produced when they are needed, eliminating large stocks of materials and finished goods. In particular, JIT seeks to achieve the following goals:

1. elimination of non­value added activities;
2. zero inventory;
3. zero defects;
4. batch sizes of one;
5. zero breakdowns;
6. a 100% on-time delivery service.

Key characteristics for successfully operating such a system are:

1. High quality: possibly through deploying TQM systems.
2. Speed: rapid throughput to meet customers’ needs.
3. Reliability: computer-aided manufacturing technology will assist.
4. Flexibility: small batch sizes and automated techniques are used.
5. Low costs: through all of the above.

Key features of companies operating in a JIT and TQM environment are:

1. high level of automation
2. high levels of overheads and low levels of direct labour costs
3. customised products produced in small batches
4. low stocks
5. emphasis on high quality and continuous improvement.

 

Business process re-engineering (BPR)

BPR is all about major changes to how business processes operate.

Business process re-engineering looks at how processes can be redesigned to improve efficiency.

Business process re- engineering involves examining business processes and radically redesigning these processes to achieve cost reduction, improved quality and customer satisfaction.

A re-engineered process has certain characteristics:

1. Often several jobs are combined into one.
2. Workers often make decisions.
3. The steps in the process are performed in a logical order.
4. Work is performed where it makes most sense.
5. Checks and controls may be reduced, and quality ‘built-in’.
6. One manager provides a single point of contact.
7. The advantages of centralised and decentralised operations are combined.

The main stages of BPR:

1. Process identification: Each process is recorded and analysed to find out whether it is Necessary, Adding value, Supporting another value adding process.
2. Process rationalization: Those processes which are not adding value, or which are not essential to supporting a value-adding process are discarded.
3. Process redesign: The remaining processes are redesigned, so that they work in the most efficient way possible. At this stage detailed operating procedures need to be produced for all processes that are to be performed manually.
4. Process reassembly: The re-engineered processes are implemented, resulting in tasks, department and an organisation that works in the most efficient manner.

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