BU247 Final Notes PDF

lOMoARcPSD|31038507 BU247 Final Notes Managerial Accounting (Wilfrid Laurier University) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by raiin ([email protected]) ...

lOMoARcPSD|31038507 BU247 Final Notes Managerial Accounting (Wilfrid Laurier University) Scan to open on Studocu Studocu is not sponsored or endorsed by any college or university Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 Agenda Chapter 5;  Activity based costing (ABC) page 114-124  Activity based costing (ABC) page 119-140 Chapter 6;  Customer profitability analysis page 161-179 Chapter 11;  The budgeting process and master budget page 329-341  Financial budgets and financial modelling page 341-348  Introduction to variance analysis page 348-353  Flexible budget variances page 353-357  Sales volume variances page 357-361,362-367  Variances analysis review page 348-367 Chapter 5 - Activity Based Cost Systems Traditional Manufacturing Costing system  In this chapter we will learn how systems assign production costs to products  Products costs provide the bridge between operating expenses and production output  Product costing systems start by assignment direct labour and direct materials cost to products 1. Calculate the cost per unit (pound, kilogram, or square meter) of each material used by a product and the cost per hour of each type of direct labour that processes the product 2. For each unit of product made, determine the quantity (number of pounds, kilograms, or square meters) of each type of material used and the quantity (number of hours) required for each type of labour 3. For each labor and material type, multiply the cost per unit (or hour) by the quantities used per product, as shown in the following equations: o Materials cost per unit = quantity of materials per unit of output x cost per materials unit o Labor cost per unit = quantity of labor hours per unit of output x cost per labor hour 4. Add up all of the individual materials and labour costs to obtain the total labor and materials cost of each product unit  Uses actual departments or cost centers for accumulating and redistributing costs  Asks how much of an allocation basis (usually based on volume) is used by the production department  Service department expenses (those associated with supporting production) are allocated to a production department based on the ratio of the allocation basis used by the production department  Use predetermined overhead rates (indirect manufacturing costs divided by volume of cost drivers) to allocate indirect costs to products  Typical volume-based cost drivers include direct labour hours and machine hours Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Adequate for companies with high-volume products with similar production volumes and batch sizes  Can lead to product cost distortion in an environment of high product variety  Example: Madison dairy and vanilla factory & multiflavoured factory page 119 Activity-Based Costing  Activity-based cost systems have been developed to eliminate product cost distortion  Gives us a better idea of what the specific costs and cost drivers are for different products  Time-driven activity-based costing systems (TDABC or time-driven ABC) estimate two parameters and then assign indirect costs similar to the way direct costs are assigned 1. The first parameter is the cost rate for each type of indirect resource o First, identify all costs insured to supply the resource (such as a machine, an indirect production employee, the computer system, factory space, a warehouse, or a truck) o Second, identify the capacity supplied by that resource  The capacity would be the hours of work provided by the machine or production employee or the space provided by the warehouse or truck  For most resources (people, equipment, machines), capacity is measured by the time supplied  The resource cost rate is calculated by dividing its costs by the capacity it supplied, usually expressed as a cost per hour or cost per minute,. For warehouses, production space, and trucks, the cost rate would be measured by cost per square foot or square meter of usable space o Capacity cost rate = cost of capacity supplied/practical capacity of resources supplied o Example: assume that indirect labour employees supply 2,500 hours of labour in total each quarter at a cost of $84,000 o The practical capacity (at 80% of theoretical) is about 2,000 hours per quarter, leading to a unit cost (per hour) of supplying indirect labor capacity  Indirect labor cost per hour = $84,000/2000  = 42$ per hour Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 2. The second parameter is an estimate of how much of each resources capacity (such as time or space) is used by the activities performed to produce the various products and services (and customers) o Capacity cost rate: o Cost of using resource (i) by product (j)= capacity cost rate of resource (i) x quantity of capacity of resource (i) used by product (j) Calculating resource capacity cost rates  Fringe benefits: benefits given to employees by their employer in addition to salaries and wages, and can be a key factor in the retention of quality employees  Indirect labour  Machinery  Look at examples on page 121 Calculating Resource time usage per product  Indirect labour time  Machine time  Look at example on page 121 Calculating product cost and profitability  Can calculate product cost and profitability once capacity cost rates for each resource and capacity demands on resources by each product are calculated  Cost systems that allocate overhead to products based on the direct labour hours of each product produced will lead to the over-costing of high-volume (standard) products and under costing of low-volume (customer/complex) products when the following situation exists; 1. Indirect and support expenses are high, especially when they exceed the cost of the allocation base itself (such as direct labour costs) 2. Product diversity is high; the plan produces both high-and-low volume products, standard and custom products, and complex and simple products  Refer to Madison Dairy report, exhibit 5-5  The results form the TDABC system were quite different form the results based on the additional cost system 1. The two speciality products, which the previous cost system had reported as the most profitable, were in fact the most unprofitable 2. The company had added large quantities of overhead resources to enable these products to be designed and produced, but their incremental revenue did not cover those costs o Managers may use insights from TDABC analysis to improve operations o Possible actions include; 1. Reduce setup times 2. Reduce time required for purchasing 3. Reduce time required for scheduling production orders 4. Increase price on unprofitable products 5. Impose minimum customer order sizes 6. Make decisions on desired product mix Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 Activity based costing pages 124-140 Measuring the cost of unused resource capacity  The Cost of unused capacity is not assigned to products produced or customers served during a period with TDABC, but should not be ignored  The cost of unused capacity remains someone's, or some departments, responsibility  Usually, one can assign unused capacity after analyzing the decision that authorized the level of capacity supplied  Such an assignment is done on a lump-sum basis; it will not be assigned to individual units of products o Eg. If the capacity was acquired to meet anticipated demands from a particular customer or a particular market segment, the costs of unused capacity due to lower than expected demands can be assigned to the person or organizational unit responsible for that customer or segment o Done as a lump sum to the organizational unit (provides feedback to managers on their supply and demand decisions)  If the unused capacity related to a particular product line then the cost of unused capacity is assigned to that product line where the demand failed to materialize  In making assignment of unused capacity costs, trace the costs at the level in the organization where decisions are made that affect the supply of capacity resources and the demand for those resources  The lump-sum assignment of unused capacity costs provides feedback to managers on their supply and demand decisions Fixed costs and variable costs in activity-based costing  Most expenses assigned by an ABC system are committed because managers have made a decision to supply these resources in advance of knowing exactly what the production volumes and mix will be  The costs of these resources will not vary with actual production volume and mix during the month, but managers can adjust their resource costs by supplying a different quantity of resources for future months, and the costs remain fixed only if managers fail to react to changes in demand and capacity utilization  Committed costs become variable via a two step procedure; o (internal) Demands for resources change either because of changes in the quantity of activities performed (eg. Changes in number of production runs or products supported) or because of changes in the efficiency of performing activities. For example; if setup times get reduced, fewer resources - employees and machine time - are required to perform the same quantity of setups o Managers make decisions to change the supply of committed resources to meet the new level of demand for the activities performed by these resources Activity in Excess of Capacity Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  If quantity of demand for a resource exceeds its capacity, the result is bottlenecks, pressure to work faster, delays, or poor-quality work  Shortages can occur on machines, as well as for human resources  Facing such shortages, companies typically increase committed costs, which is why many indirect costs increase over time Decreased Demand for Resources  Demand for indirect and support resources also can decline, either intentionally, through managerial actions, such as imposing minimum order sizes and reducing setup times, or because of competitive or economy-wide forces that lead to declines in sales  Reduced Demands for work to not immediately lead to spending decreases  The reduced demand for organizational resources lowers the cost of resources used by products, services, and customers, but this decrease is offset by an equivalent increase in the cost of unused capacity Making committed costs variable  After unused capacity has been created, committed costs will vary downward only if managers actively reduce the supply of unused resources  What enables a resource cost to be adjusted downward is a function of management decisions o First to reduce the demands for the resource o Then to lower the spending on it Managers make costs fixed  Organizations often create unused capacity through activity-based management actions  They keep existing resources in place, when demands for the activities performed by the resource have diminished  They also fail to find new activities that could be done by the unused resources already in place  The organization receives no benefits from activity based management decisions that reduce demands on their resources if capacity is not reduced or redeployed  Failure to capture benefits from activity-based management is not because their costs are fixed  The cost of these resources is only "fixed" if managers do not exploit the opportunities from the unused capacity they helped to create  Thus, making decisions, such as to reduce product variety, solely on the basis of resource usage (the ABC system), may not increase profits if managers are not prepared to reduce spending to align resource supply with the future lower levels of demand Using ABC for Budgeting and Resource Capacity Planning  ABC provides information on quantities of resources used in production and service processing  This information is useful for budgeting and resource capacity planning, by guiding; o Key process improvements o Minimum order sizes Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o Price changes o Increases or decreases in resource capacity  Start by estimating the quantity of direct labour time required for the new production plan  Next, estimate the demand for indirect production labour time  Estimate the machine times required for the new production plan  Generate a forecasted monthly profit and loss statement by multiplying the planned resource consumption of each product by the cost rate for each resource Updating the ABC Model  Managers may easily update their time-driven ABC model to reflect changes in their operating conditions  These additions can easily be incorporated by estimating the time required each time an employee performs the new activity, such as the time required to package a carton of ice cream or to receive and process a customer order  The capacity cost rate for the production employees has already been determined, so the system can quickly calculate the cost of the new activity by multiplying the time estimated by the capacity cost rate  Managers may also easily update the capacity cost rates, some factors that cause a cost rate to change; o Changes in the costs of resources supplied or resources required affect the cost rate estimates o Shifts in the efficiency of the activities affect the unit time estimate o Changes when the denominator, practical capacity, changes (eg. Working conditions) Time Equations  The time estimate to perform an activity, such as changing a machine over for a new production run, can very based on the product that has been produced, or is about to be produced  Thus, processing times can very based on the specific characteristics of a particular order and task  Time equations is a feature that enables the model to reflect how particular order and activity characteristics cause processing time to vary  Data for time equations are typically already in the company's enterprise resource planning (ERP) system  Allow the time-driven ABC model to accurately and simply reflect the variety and complexity in orders, products, and customers Service Companies  Although ABC had its origins in manufacturing companies, many service organizations today are obtaining great benefits from this approach  Focuses on the service component, not on the direct materials and direct labour costs of manufacturing operations o In practice, the actual construction of an ABC model is nearly identical for both types of companies Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o This should not be surprising since, in manufacturing companies, the ABC system focuses on the "service" component of the company  Service companies in general are ideal candidates for activity-based costing o Virtually all costs are indirect and appear to be fixed o They often do not have direct, traceable costs to serve as convenient allocation bases o They must supply virtually all their resources in advance to provide the capacity. To perform work for their customers during each period  The variable cost for most service industries is close to zero o Variable cost definition; the increase in spending resulting from an incremental transaction or customer  Step 1: calculate the capacity cost rate (look at page 132)  Step 2: time equation for the consumption of capacity Implementation issues  Not all ABC systems have been sustained or contributed to higher profitability for the company  Lack of clear business purpose o To avoid this, all ABC projects should be launched with a specific business purpose in mind  Lack of senior management commitment o It must be led by senior line managers in the organization (a committee) o To meet monthly, provide guidance and oversight, and prepare for decisions that will be made once the model has been completed  Delegating the project to consultants o Outsourcing the project to an external consulting company wont build management consensus and support, and they wont be familiar with the companies operations  Poor ABC model design o When ABC is too complicated to maintain and too complex for managers to understand and act on o It should start off simple and improve overtime based on feedback  Individual and organizational resistance to change o They may ignore the project, act hostilely towards the finance department, demand the model be simplified, or want it cut out completely  People feel threatened o A more actual costing model would reveal; o Unprofitable products o Inefficient activities and processes o Substantial unused capacity o These all threaten and embarrass managers who feel responsible Chapter 6 - Customer Profitability Analysis Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 MSDA Expenses  Companies, in addition to the costs of producing their products and services, also incur marketing, selling, distribution, and administrative expenses (MSDA)  Most of these expenses cannot be traced to individual products through casual relationships because they are not driven by the volume and mix of products that the company produces  Like the different demands by products for factory resources, customers and channels differ considerably in their use of MSDA resources  ABC can help trace MSDA expenses to customers, customer orders, and channels High Cost to serve customers  Order custom products  Small order quantities  Unpredictable order arrivals  Customized delivery  Change delivery requirements  Manual processing; high order error rates  Large amounts of pre-sales support  Large amounts of post-sales support  Pay slowly Low costs to serve customers  Order standard products  High order quantities  Predictable order arrivals  Standard delivery  No charge in delivery requirements  Electronic processing with zero defects  Little to no pre-sales support  No post-sales support  Pay on time Reporting and Displaying customer Profitability  When companies rank products, they generally find that the top-selling 20% of products generate 80% of the sales  The 80-20 rule applies well to sales revenues but not to profits  Also produces a 40-1 rule; the lowest volume 40% of the products and customers generates only 1% of total sales  Whale curve (from an ABC profitability analysis); shows cumulative customer profitability Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Plot cumulative profitability vs cumulative percentage of customers  Rank customers on the horizontal axis from most profitable to least profitable  A whale curve for cumulative profitability typically reveals; o The most profitable 20% of customers generate about 180% of total profits o The middle 60% of customers break even o The least profitable 20% of customers lose 80% of total profits, leaving the company with 100%  High profit customers appear on the left side of the whale curve o These customers should be protected o They could be vulnerable to competitive inroads o Managers should be prepared to offer discounts, incentives, and special services to retain the loyalty of these valuable customers if a competitor threatens  Low profile customers appear on the right side of the whale curve o These customers may have unpredictable order patterns, small order quantities for customized products , or large demands on technical or sales personnel o Managers can use ABC to help understand why these customers are unprofitable, and to provide insight on how to transform unprofitable customers into profitable ones Customer Costs in Service companies  Service companies must focus on customer costs and profitability because the variation in demand for organizational resources is much more customer driven than in manufacturing companies  Customer behavior determines the quantity of demands for organizational resources that produce and deliver the service to customers  Measuring revenues and costs at the customer level provides the company with far more relevant and useful information than at the product level Increasing Customer Profitability  Manufacturing and service companies alike have many options to transform their breakeven or loss customers into profitable ones o Process improvements Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o Improve the processes used to produce, sell, deliver, and service the customer o To lower the cost of serving customers o Example: if a company receives a large number of small orders, the company could;  Strive to reduce costs of setup and order handling  Encourage customers to place orders electronically o Activity based pricing o Pricing is the most powerful tool a company can use to transform unprofitable custoemrs into profitable ones o Establish a base price for producing and delivering a standard quality for each standard product and also deploy menu-based pricing to allow the customer to select the features and services he or she wishes to receive and pay for  Alternatively, the company may choose to earn a margin on special services by pricing such services above the costs of providing the services o Activity based pricing process orders, not products o Managing relationships o Enhance the customer relationship to improve margins and lower the cost to serve that customer  Persuading customers to use a greater scope of the companies products and services  Establish minimum order sizes  The margins from increased purchases contribute to covering customer-related costs that do not increase proportionately with volume, such as the cost of the salesperson assigned to the account  Some customers may be unprofitable only because it is the start of the relationship with the company o Pricing waterfall o Before giving a customer a price increase, the company should examine the many ways it has already reduced the effective price the customer actually pays o Small concessions offered by different organizational units may accumulate into large revenue leaks o Pricing waterfall charts list the multiple revenue leaks from the list price caused by special allowances and discounts granted to the customer Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o This chart is commonly referred to as the pricing waterfall because of the multiple revenue leaks from list price caused by special allowances and discounts granted to obtain the order and build customer loyalty o To remedy this problem, companies now extend their ABC systems to trace all revenue deductions, as well as promotional costs and allowances, to individual orders and customers so that they can calculate actual, realized profit or loss customer by customer  Use a comprehensive customer operating income statement (p170), or  A customer profitability map (p.171) o Mapping customer profitability;  o Profitability depends on whether and how much the net product margins recover the customer-specific costs Sales Person Incentives  Many breakeven or unprofitable customer relationships occur because salespeople have incentives to generate sales, not profit  A typical salespersons compensation plan sets minimum quotas and provides incentive commissions based on sales revenue  There may be special rewards such as vacation trips for achieving sales revenues above a stretch goal Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Such salesperson incentives and compensation arrangements encourage salespeople to close deals and generate revenues without regard to the cost of fulfilling the special arrangements negotiated in the deal and the impact of discounts and allowances granted to close the deal  Companies base salespeople's compensation and rewards on revenues because it is a simple measure, generally easy to calculate, and consistent with the salespersons mission to generate sales  Enterprise resource planning (ERP) and customer relationship management (CRM) software systems can electronically capture all the features of sales and production orders Life Cycle Profitability  Companies invest considerable resources to attract new customers, who may turn out to be unprofitable, especially if the relationship is short  By knowing the characteristics of profitable customers, companies can direct their marketing efforts to specific segments that are most likely to yield profitable customers  Because of high acquisition costs and the time required to establish a broad and deep relationship, even attractive new customers may be initially unprofitable  Companies must distinguish the economics of their new customers from those who have been customers for a while, therefore in addition to recognizing demands by customers across multiple products and services, companies must also forecast the longitudinal variation of customers over time to calculate their total life-cycle profitability  Example;  Consider a company that has just spent $5 million on a campaign to acquire new customers. The campaign yielded 5,000 new customers, or an average cost of $1000 per customer acquired o Customer A purchased products and services that generated a new margin of $300 per year (after deducting all production and MSDA costs attributable to the relationship). Customer A however, left for a competitor after 3 years o Customer B purchased products and services yielding a net margin of $275 per year and defected after 5 years  It seems that customer A is more profitable than customer B as they bring in a higher annual profit per year, however the system failed to see that the 3 years of $300 net margin did not repay the initial $1000 acquisition cost, so A was actually a loss customer over its lifetime with the company  Calculating customer lifetime value (CLV);  Where; o Mt= margin (revenue less cost) from customer in year t o Ct= any additional costs to serve (and retain) customer in year t o i= cost of capital (for example 10%)  If Mt, ct, and rt are about the same each year, and n is large, the following results; Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  The equation assumes that the company can estimate the probability of retaining a customer from one year to the next, which it called the retention rate, r  Customer lifetime value calculations use the following parameters; o Initial cost to acquire the customer o Profits or losses from the customer each year o Any additional costs to retain the customer in a year o The probability of retaining the customer each year or the known length of the relationship Measuring customer performance with nonfinancial metrics  Focusing on only financial metrics may cause a company to take actions that could improve short-term financial performance but damage long-term customer relationships  Important nonfinancial metrics for managing performance with custoemrs; o Customer satisfaction o Customer loyalty o Net promoter score  Customer Satisfaction o Most companies attempt to measure customer satisfaction by using surveys o Typical survey questions address; o Product quality o Ease of ordering o Responsiveness of company personnel o Customer complaint services  Customer loyalty o A customers satisfaction is an attitude or belief stemming from a feeling that the product or service has generally delivered on the customers expectation of performance o But attitudes and beliefs are not actions; a customers attitude toward a product of company does not readily translate into the desired behavior of repeated and increased purchases of the product or service, or customer loyalty o Companies can measure loyalty directly by actual repeat purchasing behavior o Loyal customers are valuable for several reasons; o They have a greater likelihood to repurchase, an the costs to retain them are generally mush lower than the costs to acquire an entirely new customer o They can persuade others, such as through word of mouth, to become new customers; they can become references for potential future customers Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o They are less likely to defect when a competitor offers a similar products at the same or slightly lower price o They are often willing to pay a price premium to retain a known and trusted relationship with a key supplier o They are willing to collaborate with the supplier to improve performance and develop new products  One scholar has proposed that companies view their customer satisfaction and loyalty along a five-stage hierarchy: o Satisfied customers, as measured by how well a customer’s expectations have been met or exceeded in an individual transaction or long-term relationship o Loyal customers, as measured by the customer devoting an increasing share of wallet for repeat purchases from the same supplier o Committed customers, who not only purchase frequently from the supplier but also tell others about the supplier’s great products and service o Apostle customers, the committed customers who have credibility and authority when they recommend the supplier to friends, neighbors, and colleagues (for example, respected and opinion-leading surgeons have great credibility when they attest to their satisfaction with a new medical instrument) o Customer “owners,” who take responsibility for the continuing success of the supplier’s product or service (for example, some of Southwest Airlines’ most loyal customers are willing to interview prospective flight attendants to help select the ones they would most want to serve them, and Procter & Gamble has established an interactive site so that its loyal customers can provide feedback on existing products and suggestions for improving them or for entirely new products)  Strive to have more customers in 3, 4, and 5 because their willingness to recommend the company to others and to collaborate with the company to continually improve product features and service makes these customers far more valuable, with a much higher CLV, than customers who are merely satisfied with the most recent transaction  The net promoter score o Some researchers (Fred Reichheld) have found that there is a low correlation between customer satisfaction and future revenue growth o Customers often remain with their current supplier because of inertia, high switching costs, or lack of an alternative supplier o A customers willingness to recommend a company is strongly correlated to future sales growth o Customer surveys have been expanded to ask if a customer is willing to recommend the company o 10 point scale for customers to respond to this question: Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o 9-10 are "promoters" o 7-8 are "passively satisfied" o 1-6 are "detractors" o Based on his work, many companies now calculate a new promoter score (NPS). Defined as the percentage of customers who are promoters (score of 9-10) less the percentage who are detractors (score through 1-6) Chapter 11 - Using budgets for planning and Coordination Capacity Related and Flexible Resources  So far , we called costs that varied with the activity level in the firm variable costs; costs that did not change with changes in activity levels we called fixed, or capacity related costs  For decisions affecting the short term, the firms fixed costs are considered to be given and fixed  Therefore, in the short run; o The costs that are relevant to the firm in the short run, because they are the only ones that are controllable, are variable costs o The only relevant costs are controllable costs, which are variable costs  The budgeting process determines the planned level of most variable costs The Role of budgets and budgeting - The budgeting process  Budgets serve as a control for managers within the business units of an organization  A budget is a planning tool, but also serves as a control on the behaviour of people by setting limits on what can be spent in each budget category  Budgets play a central role in the relationship between planning and control  Budgets reflect in quantitative terms how the allocate financial resources to each part of an organization, based on the planned activities and short-run objectives of that part of the organization  A budget is a quantitative expression of the planned money inflows and outflows that reveal whether a financial plan will meet organizational objectives  Budgeting is the process of preparing budgets  Budgets provide a way to communicate the organizations short-term goals to its employees  Budgeting the activities of each unit can; o Reflect how well unit managers understand the organizations goals, so that they can align their actives and spending priorities with those goals o Provide an opportunity for the organizations senior planners to correct misperceptions about the organizations goals  Budgeting also serves to coordinate the many activities of an organization, such as the effect of sales levels on needed purchasing, production, and administrative activities and on the number of employees that must be hired to serve the customer Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Budgeting also provides a way to communicate the organizations short-term goals to its employees  Planning and control and the role of budgets;  Can use a simulation analysis, also known as a what-if analysis which helps managers choose a course of aciton among many alternatives by identifying a decisions consequence in a complex system with many interdependencies  Budgets can also help anticipate potential problems and can serve as a tool to help provide solutions to these problems such as; o Borrowing needs - the budget reflects the cash cycle and provides information to anticipate cash shortages o If budget planning indicates that the organizations sales potential exceeds its manufacturing potential, then the organization can develop a plan to put more capacity in place or to reduce planned sales  Budgeting reflects this cash cycle; o The cash cycle provides information to help the organization plan the borrowing needed to finance the inventory buildup early in the cash cycle The Elements of Budgeting Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Budgeting involves forecasting the demand for four types of resources over different time periods 1. Flexible resources that create variable costs; o Flexible resources are those that can be acquired or disposed of in the short term, such as the lumber, glue, and varnish used in the furniture factory or, based on estimates of the number of automobiles to be assembled, the number of tires and automobile assembly plant needs to acquire 2. Intermediate-term capacity resources that create fixed costs; o An example is forecasting the need for rental storage space that might be contracted on a quarterly, semi- annual or annual basis 3. Resources that, in the intermediate run and long run, enhances the potential of the organizations strategy; o These are discretionary expenditures, which include research and development, employee training, the maintenance of capacity resources, advertising, and promotion. o These discretionary expenditures do not provide capacity, nor do they vary with the level of organizational activity 4. Long-term capacity resources that create fixed costs; o An example is the new fabrication facility for a computer chip manufacturer, which might take several years to plan and build and might be used for 10 years  2 major types of budgets make up the master budget; 1. Operating budgets o Summarize the level of activities such as sales, purchasing, and production 2. Financial budgets o Such as balance sheets, income statements, and cash flow statements, identify the expected financial consequences of the activities summarized in the operating budgets Behavioral Considerations in Budgeting  Game playing is inherent in the budget process  "gaming the budgeting process" refers to when managers have an incentive to misrepresent their information o Caused when budget planners solicit information from mangers and employees who are in the best position to know performance potential and then incorporate that into the budget (that is used later to evaluate actual performance) Budget components  The master budget summarizes different components of the budget Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  The dashed lines from the expected financial results (box 11 and 12) show how the estimated financial consequences from the organizations tentative budgets can influence the organizations plans and objects  The dashed lines illustrate a recursive process in which planners compare projected financial results with the organizations financial goals  If initial budgets prove infeasible, or financially unacceptable, planners repeat the budgeting cycle with a new set of decisions until the results are both feasible and financially acceptable  The budgeting process describes the acquisition, production, selling, and logistical activities performed during the budget period  The master budget process includes two broad sets of outputs; o The plans or operating budgets that operating personnel use to guide operations (boxes 2,3,5,6,7,8,9) o The expected or financial results (boxes 11 and 12), planners usually present the expected or projected financial results in three forms; o A statement of expected cash flows o The projected balance sheet o The projected income statement o Managers call the projected statement of cash flows., balance sheet, and projected income statement pro forma financial statements (pro forma means provide in advance)  Two major types of budgets comprise the master budget; o Operating budgets o Summarize the level of activities such as sales, purchasing, and production o Financial budgets o Identify the expected financial consequences of the activities summarized in the operating budgets Operating budgets  Operating budgets typically consist of the following six operating plans; 1. The sales plan (box 2) identifies the planned level of sales for each product Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 2. The capital spending plan (box 3) specifies the long-term capital investments, such as buildings and equipment, that must be made to meet activity level objectives 3. The production plan (box 5) schedules required production 4. The materials purchasing plan (box 7) schedules required purchasing activities 5. The labor hiring and training plan (box 8) specifies the number of people the organization must hire or release to achieve its activity level objectives and, based on those numbers, the needed hiring, training, and counseling out policies requirements 6. The administrative and discretionary spending plan (box 9) includes administration, staffing, research and development, and advertising  Operating budgets specify the expected resource requirements of selling, capital spending, manufacturing, purchasing, labor management, and administrative activities during the budget period  Operations personnel use those plans represented in the operating budget to guide and coordinate the level of various activities during the budgeting period  Operations personnel also record data from current operations that can be used to develop future budgets Financial Budgets  Planners prepare the projected balance sheet and projected income statement to estimate the financial consequences of investment, production, and sales plans  Planners use the statement of projected cash flows in two ways; o To plan when excess cash will be generated so that it can be used to make short-term investments rather than simply holding cash during the short term o To plan how to meet any cash shortages The budgeting process Illustrated - Oxford Tole Art  Sales plan o The budgeting process is influenced strongly by the sales demand forecast - an estimate of the sales demand at a specific selling price o Most find a balance between detailed planning and the cost and practicality of detailed scheduling o Done by grouping products into pools so that each product is given pool places roughly equivalent demands on the organizations resources so that planning is simplified o Organizations with many products and services may choose to budget at a more aggregated level, such as by product line o Provides the basis for production plans o Labor o Materials o Production capacity o Cash  The production plan Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o Planners determine a production plan by matching the completed sales plan with the organizations inventory policy and capacity level o The plan identifies the intended production during each of the interim periods comprising the annual budget period o A level production strategy (That uses highly skilled employees or equipment dedicated to producing a single product) is not flexible because the employees and equipment aren't transferable to other jobs within the organization o Just-in time inventory; only an order can trigger production (demand drives the production plan directly)  Developing the Spending plans o Based on the production plan, developing the following; o Materials purchasing plan are driven by the cycle of the organizations production plans and the suppliers production plans (by the purchasing group) o Labor hiring and production plan (by the personnel and production groups) o Discretionary spending plan (by other decision makers) o Capital spending plan (by appropriate authority)  Choosing the capacity levels o Analysing short-term activities by considering efficiency o Evaluate intermediate and long term activities by using efficiency and effectiveness considerations o Three types of resources determine capacity; o Short term flexible resources o Provides ability to use existing capacity o Raw materials, supplies, hourly paid labour o Intermediate term capacity resources o General-purpose capacity transferable among organizations o Employees, general purpose equipment o Long-term capacity resources o Special-purpose capacity customized for the organizations use o Buildings, special-purpose equipment  Handling infeasible production plans o If a production plan is infeasible because projected production exceeds available capacity, they must make provisions to acquire more capacity to reduce the planned level of production o Planners use forecasted demand to plan activity levels and provide required capacity o If planners find the tentative production plan infeasible, then they have to make provisions to; o Acquire more capacity, or o Reduce the planned level of production Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 Interpreting the Production Plan  Production is the lessor of; o Total demand o Production capacity  Demand is the quantity customers are willing to buy at the state price   Production capacity is the minimum of; o The long-term capacity o The intermediate-term capacity o The short-term capacity  3 factors that drive planning; o Sales demand, which is the quantity customers are willing to buy at the stated price o The capacity levels chose o Production output quantity Financial Budgets and financial Modelling pg. 341-348 The financial Plans  Once the planners have developed the production, and capacity plans, they can prepare a financial summary of the tentative operating plans  Projected balance sheet o An overall evaluation of the net effect of operating and financing decisions during the budget period  Projected income statement o An overall test of the profitability of the proposed activities  Projected cash flows statement o Helps an organization identify if and when it will require external financing The cash flow statement  The cash flow statement has three sections; 1. Cash inflows from retail cash sales and collections of dealer receivables 2. Cash outflow's o For flexible resources that are acquired and consumed in the short term (buoys, paint, other supplies, packaging, and shipping) o For capacity resources that are acquired and consumed in the intermediate and long-term (painters, shop rent, managers salary, other shop costs, interest paid, and advertising costs) o The difference between cash inflows from revenues and cash outflows from expenditures is called the net cash flows from operations Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 oCash outflow= units of flexible purchased x price per unit of flexible resource o Cash outflow= this months expenditure for the capacity resource 3. Results of financing operations o This includes any borrowing or repayment of loans of equity financing transactions  In summary for each month, the format of the cash flow statement is as follows; 1.  Cash flow forecast:  Projected balance shee   Income statement; Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Ending cash for oxford tole arts; Results of Financing Operations  Summarizes the effects on cash of transactions that are not a part of the normal operating activities  The major sources and uses of cash in most organizations are (1) operations (2) investments or withdrawals by the owner in an unincorporated organization, (3) long-term financing activities related to issuing or retiring stock or debt, and (4) short-term financing activities  Short-term financing often involves obtaining a line of credit, secured or unsecured, with a financial institution  The format of the financing section of the cash flow statement for oxford tole art provides information about the line-of-credit balance  Many organizations include the line of credit information in the cash flow statement because financial statement readers should be aware of the limits that can potentially constrain operations  Includes the effects of;  Issuing or retiring stock or debt  Short term financing Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 Using the Financial Plans  Organizations can raise money from outsiders by borrowing from banks, issuing debt, or selling shares of equity  A cash flow forecast helps organizations identify when it will require external financing  Also shows whether any projected cash shortage will be temporary or cyclical or permanent  Temporary/cyclical can be met by a line of credit arrangement  Permanent would require either all of a long-term loan from the bank, further investment by the owners, or investment by new owners  Projected income statement and balance sheet  General assessment of operating efficiencies Using the projected results  Planners use the budget information to accomplish the following; 1. Identify broad resource requirements; o This helps develop plans to put needed resources in place. For example, April can use the activity forecast to plan when the organization will have to hire and train temporary help 2. Identify potential problems; o This helps to avoid problems or to deal with them systematically 3. Compare projected operating and financial results: o These comparisons within an organization serve as a measure for comparison with the operating and financial results of competitors What if analysis  Used to evaluate alternative strategies  Structure and information required to prepare the master budget can be used to easily provide the basis for what-if analysis o Evaluate decision making alternatives o Sensitive analysis  The process of selectively varying a plans or budgets key estimates for the purpose of identifying over what range a decision option is preferred Introduction to Variance analysis pg 349-353 Comparing Actual and Planned Results  To understand results, such as production and financial outcomes, organizations use variance analysis to compare planned or budgeted results in the master budget with actual results Variance Analysis  Budgets are prepared for specific periods so that managers can compare actual results for the period with planned results for the period Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Variance analysis has many forms that can result in complex measures, but its basis is very simple; o An actual cost or actual revenue amount is compared with a target cost of target revenue amount to identify the difference, which is called a variance  Variance analysis; comparison of planned (or budgeted) results with actual results  A variance represents a departure from what was budgeted or planned  What caused the variance and the size of that variance will trigger an investigation to determine its cause and what should be done to correct that variance  Budgets or planned costs can come from three sources; o Standards established by industrial engineers, such as cost of steel that should go into an automobile door based on the doors specifications o Previous periods performance, such as the average cost of steel per door that was made in the last budget period o A performance level achieved by a competitor - usually called a benchmark and based on best-in-class results; such as the cost of steel per comparable door achieved by a competitor who is viewed as the most efficient  The financial numbers used in variance analysis for flexible resources are the product of a price and a quantity component o Planned or budgeted amount = standard price per unit x budgeted quality o While; o Actual amount = actual price per unit x actual quantity  Variance analysis explains the difference between planned and actual costs by evaluating; o Differences between planned and actual prices o Differences between planned and actual quantities  Managers focus separately on prices and quantities because in most organizations; o One department or division is responsible for the acquisition of a resource and determining the actual price o A different department uses the resources and determines the quantity of the resource  A variance is a signal that is part of a control system for monitoring results, and thus variances provide a signal that operations did not go as planned Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Supervisory personnel use variances as overall checks on how well the people who are managing day-to-day operations are doing what they should be doing  When compared to the performance of other organizations engaged in comparable tasks, variances show the effectiveness of the control system that operations people are using Basic Variance Analysis  If managers learn that specific actions they took helped lower the actual costs, then they can obtain further cost savings by repeating those actions on similar jobs in the future  If the factors causing actual costs to be higher than expected can be identified, then actions may be taken to prevent those factors from recurring in the future  If cost changes are likely to be permanent, cost information can be updated for future jobs Planned and Static Budget  The static budget is the planned budget that the organization prepares at the beginning of the period  It is based on the planned level of sales, on the standard selling price per unit, and on the standard costs (standard variable costs per unit and standard total fixed costs) o All expected prices, and costs and unit sales  Therefore, in what follows when an organization wants to compare revenue and costs to the planned budget they use the static budget numbers  The static budget numbers depend on; o The projected volume of activity o The standard for the quantity of each of direct materials, direct labour, and variable overhead o The standard cost per unit of each of the budgeted items  If any of these items differ from the forecasted amount, the actual income differs from the master budget First Level Variances  The first level variance for a budget item is the difference between the actual amount and the static budget amount  Static budget variance; compares actual results with the results in the static budget (or expected results)  Variances are computed by subtracting the static budget item from the actual item, therefore; o Variances are favourable (F) if the actual costs are less than estimated static budget costs o Variances are unfavourable (U) when actual costs exceed estimated static budget costs Decomposing the Variances  A flexible budget adjusts the quantity forecast in the static budget for the difference between planned volume and actual volume Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Therefore, the flexible budget reflects a forecast based on the level of volume that is actually achieved rather than a planned volume that underlies the static budget  Cost differences between the static budget and the flexible budget are called planning variances o It reflects the difference between planned output and actual output o Arise entirely because the planned volume of activity was not realized  What is the flexible budget used for? o To compare with the static budget to determine the difference in net income due to sales quantity (flexible budget holds everything constant with static budget except for unit sales, so the difference in results must be due to difference in unit sales) o To compare with the actual budget to determine the difference in the net income due to different prices and costs (flexible budget holds everything constant with actual budget except for dollar values, so the difference in results must be different due to different dollar values)  Actual results = reflects the actual sales units, the actual selling price per unit, and all the actual costs Second Level Variance; Planning and flexible Budget Variances  Planning Variance;  Cost differences between the static budget and the flexible budget are called planning variances o It reflects the difference between planned output and actual output o Arise entirely because the planned volume of activity was not realized  Both are built using the exact same standard (budgeting) information that are the selling price per unit and the standard costs  Shows the difference in the sales volume impacted the income  Flexible budget variance:  Flexible budget variances are the differences between the flexible budget and the actual results  Both are built using the actual sales volume, but actual results are based on everything actual, while the flexible budget is based on everything standard (except for the sales units)  While the planning variance isolates the volume effect, this variance isolates the effect of everything else  Helps managers identify all other causes of this life-level variance. These causes include; o Selling price per unit o The use of resources that is to say the quantity of the variable resources consumed for production o And the cost of resources (which we refer to as the price of resources) which includes variable costs of resources as well as total fixed costs Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 Third Level Variance;  The flexible budget variance is broken into more specific variances  Direct material flexible budget variances and direct labor and variable overhead flexible budget variances can be decomposed further into o Quantity or efficiency variances o Price or rate variances  These are referred to third-level variances because together they explain the flexible budget component of the second-level variance  Sales price variance (revenue variance)  Compares the actual selling price per unit with the standard one  Sales price variance= actual # of units sold x (actual price per unit - planned price per unit)  Fixed-cost Variance  Spending on fixed costs may fluctuate from period to period so it is important to monitor differences between planned and actual costs  Fixed cost variance= actual fixed costs - planned (budgeted) fixed costs  Quantity / Efficiency Variance  Direct materials Quantity variance = (AQ-SQ) x SP o Where AQ=actual quantity of materials used o SQ= standard quantity of materials allows for the production level achieved o SP = standard price of materials  Direct Labor efficiency variance = (AH - SH) x SR o Where AH= actual number of direct labour hours o SR= standard quantity of materials allowed for the production level achieved o SP= standard price of materials  Price/ Rate Variance  Direct materials price variance = (AP-SP) x AQ o Where; AP= actual price of materials o SP= estimated or standard price of materials o AQ= actual quantity of materials used  Direct Labor rate variance = (AR-SR) x AH o Where; AH= actual number of direct labour hours o AR= Actual wage rate o SR= Standard rate  The sum of the rate variance and the efficiency variance equals the total flexible budget direct labour variance  Variable Overhead Variance  VOH variances are calculated like those for direct materials and direct labor, if the cost driver for VOH is driect labor hours then; o VOH efficiency variance = (AH-SH) x SR o VOH rate variance = (AR -SR) x AH  Total cost variance; the sum of all cost variance (DM and DL variances, any other VS variances, VOH variance, FC variance)  Sales price variances Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Sales price effects; o Actual number of units sold x (actual price per unit - planned price per unit) Sales Volume Variances (planning variances) pg 357-367  Recap: o The planning variance, is the difference between the static budget and the flexible budget incomes. The planning variance reflects the change in income attributable to operating at a different level of production and sales than planned o The flexible budget variance, represents the cumulative effect of not meeting standards for the use and cost of direct materials, direct labor, variable manufacturing overhead, fixed costs, and selling price per unit  We have studied how managers factor cost variances into different components in order to signal to management where costs deviated from the plan or target amounts, but what about income?  The planning variance for a single product organization can be computed as follows; o Planning variance = (flexible budget unit sales - static budget unit sales) x contribution margin per unit o = flexible budget CM - Static budget CM o This formula reflects that there are no fixed cost variances between the static budget and flexible budget, so we need only focus on contribution margin differences between the static and flexible budgets  Since fixed costs are in the static budget and the flexible budget the planning variance equals the difference in static budget contribution margin and the flexible budget contribution margin  By convention the planning variance is computed by subtracting the static budget contribution margin from the flexible budget contribution margin  Planning variance (volume effect) o Help managers explain the difference between the actual income and the static budget income by focusing exclusively on the variable in the sales volume o Broken down into two parts; sales mix variance and sales quantity variance  In a firm with multiple products, volume related revenue differences can arise in two ways; 1. When the mix (the percentage of the total of each products sales) was different than planned, a sales mix variance is created;  Sales mix variance (computed for each product)  Measures the effect of the difference in sales mix between the static budget and flexible budget on contribution margin  Sales mix Variance; o = actual total sales units of all products x (actual sales mix % of this product - static budget sales mix of the product) x static budget CM per unit of this product Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o Note that now we are dealing with contribution, so a positive variance is favorable 2. When the total volume of sales is different than planned, this is called the sales quantity variance, and for each product, the sales quantity variance is computed as follows;  Sales Quantity variance; o Measures the effect of the quantity of sales differences between the static budget and the flexible budget on CM o = (actual total sales units of all products - static budget total sales units of all products) x static budget sales mix percentage of this product x Static budget contribution margin per unit of this product  Now we turn to the effects of the broad product market  We can decompose the sales quantity variance into two components; 1. Market share Variance  The market share variance measures the effect on contribution margin as the company's market share changes, at the level of actual total industry sales  In effect, the market share variance provides a basis for relative performance evaluation against industry wide performance  Market share variance: o = actual total industry sales of all products x (actual market share - budget market share) x weighted average contribution margin per unit 2. Market size Variance  The market size variance measures the effect, given the company's planned market share, on contribution margin as planned and actual industry sales diverge o = (actual total industry sales - planned total industry sales) x planned market share x weighted average contribution margin per unit  The analysis of the planning variance process; Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 Budgeting in Service and Not-for-profit organizations  Helps organizations perform their planning function by coordinating and formalizing responsibilities and relationships and communicating the expected plans  Main focus of the budgeting process; o Manufacturing - sales and manufacturing activities o Natural resource - sales, resource availability, and acquisition  Focus is on balancing demand with the availability of natural resources, such as minerals, fish, or wood o Service - sales activities and staffing requirements  The focus is on balancing demand and the organizations ability to provide services, which is determined by the level and mix of skills in the organization o NFP - raising revenues and controlling expenditures  The focus of budgeting has been to balance revenues raised by taxes or donations with spending demands  Appropriations; planned cash outflows and spending plans in government agencies Periodic and Continuous Budgeting  Period budgeting is typically performed once per budget period - usually once a year  Planners pay, however, update or revise the budgets  Continuous budgeting, as one budget period passes (usually a month or quarter), planners drop that budget period from the master budget and add a future budget period in its place  The length of the budget period reflects the competitive forces, skill requirements, and technology changes that the organization faces Downloaded by raiin ([email protected])  lOMoARcPSD|31038507  Advocates of period budgeting argue that continuous budgeting takes too much time and effort and that periodic budgeting provides virtually the same benefits at a smaller cost  Advocates for continuous budgeting argue that it keeps the organization planning, and assessing, and thinking, strategically year-round rather than just once a year at budget time Controlling Discretionary Expenditures  Organizations generally use one of three general approaches to budget discretionary expenditures o Incremental budgeting o Zero-based budgeting o Project funding  Each has benefits relative to the others  Incremental budgeting o Incremental budgeting bases a periods expenditure level on the amount spent during the previous period o If the total budget for discretionary items increases by 10% then;  Each discretionary item is allowed to increase 10%, or  All items may experience an across the board increase of, for example, 5% and the remaining 5% increase may be allocated based on merit  Zero based budgeting o Zero based budgeting (ZBB) requires that proponents of discretionary expenditures continuously justify every expenditure o The starting point for each line item is zero o Zero-based budgeting arose, in part, to combat indiscriminate incremental budgets where projects take on a life or their own and resist going out of existence o All expenses must be justified for each new period, budgets are then built around what is needed for the upcoming period, regardless of whether each budget is higher or lower than the other one o Zero based budgeting is inappropriate for budgeting costs that very in proportion to production, such as the amount of wood used in a furniture factory o Organizations resources are allocated to the spending proposals they think will best achieve the organizations goals o Used primarily to assess government expenditures o In profit-seeking organizations, ZBB has been applies only to discretionary expenditures o For engineered costs (for example wood to make chairs), ZBB could be effective when combines with the reengineering approach  Project funding o Intermediate solution to mitigate the disadvantages of ZZB and incremental budgeting o A proposal is made for discretionary expenditures with a specific time horizon or sunset provision Downloaded by raiin ([email protected])  lOMoARcPSD|31038507 o Projects with indefinite lives (sometimes called programs) should be continuously reviews to ensure that they are living up to their intended purposes o Requests to extent or modify the project must be approved separately Managing the budgeting process  Many organizations use a budget team, headed by the organizations budget director, to coordinate the budgeting process  The budget team usually reports to a budget committee, which generally includes a chief executive officer, the chief operating officer, and the senior executive vice presidents  The composition of the budget committee reflects the role of the budget as the planning document that reflects and relates to the organizations strategy and objectives  Using a budget committee may signal to other employees that budgeting is something that is relevant only for senior management  Senior management must take steps to ensure that the organizations members affected by the budget do not perceive the budget and the budgeting process as something beyond their control or responsibilities Beyond Budgeting Approach  Differs in two fundamental ways from traditional budgeting; o Targets are developed based on stretch goals tied to peers, competitors, and key global benchmarks  Not based on internal artificial goals  Managers are more motivated o Provides a more decentralized way of budgeting  Managers are more accountable to their teams  Employees are more motivated Downloaded by raiin ([email protected])