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AC2105
Accounting for Decision
Making & Control
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 Seminar 1
Agency Theory
Agency problems arise due to:
- Goal incongruence: individuals act in their self-interest to maximize their utility (not the principal’s utility)
- Information asymmetry: agent possesses more information than the principal
- Free rider problem: output of agent cannot be directly observed
Horizon problem: agent expects to leave the organization before the principal > focuses on short-term
actions/results

Solution: Organisational Architecture (to structure the agent’s incentives such that principal’s utility is
maximized when agent’s utility is maximized)
a) Performance Evaluation (measure performance > in areas where agent has decision rights)
- Objective and/or subjective
- Financial and/or non-financial
- Eg using BSC
b) Rewards and Incentives (reward performance > in areas where agent’s performance is being measured)
- Monetary and/or non-monetary
c) Empowerment (partition decision rights > exercise of rights can be measured and rewarded)
- Centralization vs decentralization > depends on where knowledge resides at, accountability for the result,
timeliness
1. Initiation (Decision management)
2. Ratification (Decision control)
3. Implementation (Decision management)
4. Monitoring (Decision control)
Organizational Architecture affects and is affected by:
- Technological Innovation
- Market Conditions
 Which affect Business Strategy (asset structure, customer base, nature of knowledge creation)

Simon’s 4 levers of control

Belief systems Boundary Interactive Diagnostic Control
systems systems systems
Formal/Informal control system Informal Informal Formal Formal
Empowerment/control Empowerment Control Empowerment Control
Focus Core values Risks to be Strategic Critical performance
avoided uncertainties variables

Seminar 2
Porter’s 3 generic strategies
Cost Leadership—outperform competitors by producing at the lowest cost, consistent with quality demanded
by the consumer
Differentiation—creating value for the customer through product innovation, product features, customer
service, etc. The customer is willing to pay more for these added values.

*Stuck in the middle: not as unique and not as cheap compared to its competitors
Value chain analysis
An analysis tool organizations use to identify the specific steps required to provide a competitive product or
service to the customer, by identifying:
- Understand the competitive strategy of the company (cost leadership/differentiation)
- Identify the value-chain activities (primary and support activities based on industry/environment)
- Identify the costs and profit margins in the value chain activities
- Develop the competitive advantage (cost leadership or differentiation) by reducing cost or adding value
Reducing cost: activity can be outsourced, consolidation of orders can produce bulk discount, using
alternative suppliers, etc
Adding value: additional services, address sustainability concerns
> value-chain assist in determining the type of responsibility centres
*Value-added analysis: high value-added activity or low value-added activity

5 Steps of Strategic Decision Making

1. Determine the strategic issues surrounding the problem
2. Identify the alternative actions
3. Obtain information and conduct analyses of the alternatives (eg net profit before and after +
assumptions)
4. Based on strategy and analysis, choose and implement the desired alternative
5. Provide an on-going evaluation of the effectiveness of implementation in step 4.

Volume-based costing - steps

1. Assign overhead costs to cost pools such as a plant or department (indirect costs) or to cost objects
(direct costs)
2. Assign activity costs pools to cost objects using a volume-based rate

Volume-based costing - drawbacks

- Possible costing inaccuracies (product cross-subsidisation) as indirect costs do not always occur in
proportion to output volume

Activity-based Costing (ABC) - steps

1. Assign overhead costs to activity cost pools such as cutting cloth (indirect costs) or to cost objects
(direct costs) using an activity consumption rate
2. Assign activity costs pools to cost objects using an activity consumption rate

Activity-based Costing (ABC) - details

1. Identify resource costs and activities (using activity analysis)
Can the activity be eliminated?
How does the activity consume resources?
Unit-level activity: performed on each individual unit of product/service
Production-related depreciation of machinery/unit
Energy costs/unit
Batch-level activity: performed for each batch/group of products/services
Machine-setup costs
Quality control costs
Energy costs/batch
Sales return costs
Delivery costs
Salaries of workers transporting goods within the factory
Product-level activity: supports the production of a specific product/service
Salaries of product line purchasing managers
Quality control costs
Product development costs (RandD)
Depreciation and machinery costs for specialized machinery dedicated to production of a
single product/service line
Facility-level activity: supports overall operations
Depreciation of factory (in general)
Security costs for the factory
Insurance and property costs for a factory
Salaries of plant managers
 2. Assign resource costs to activities (using resource consumption cost drivers eg number of labour hours,
employees)
3. Assign activity costs to cost objects (using resource consumption cost drivers eg number of purchase
orders, number of labour hours)

Activity-based Costing (ABC) - benefits

- Better profitability measures (more accurate costs)
- Provision of information for process improvement
- Improved cost planning (better estimates of costs)
- Helps identify and control cost of unused capacity
- *Eliminates the issue of cross-subsidisation faced by volume-based costing (volume-based costing tends to
undercost low-volume products and overcost high-volume products)

Activity-based Costing (ABC) - Multiple-Stage ABC

Resource costs are assigned to certain activities which in turn are assigned to other activities, before being
assigned to a final cost object

Activity-based Costing (ABC) - Time-Driven ABC

Assigns resource cost directly to cost objects using the cost per time unit of supplying the resource, rather than
first assigning cost to activities and then from activities to cost objects (if repetitive steps)

Activity-based Costing (ABC) – used for Activity-based Management (ABM)

Manages resources and activities to improve the value of products or services to customers and increase the
firm’s competitiveness and profitability
- Operational ABM: focus is on efficiency (activity analysis, business process improvement, total quality
management, performance management)
- Strategic ABM: focus is on selecting activities and customers (process design, customer profitability
analysis, value chain analysis)

Resource Consumption Accounting (RCA)

Uses an activity/process view but integrates marginal costs and a detailed resource consumption analysis to
generate information for decision support (focus is on attributing costs to cost objects for decision support)

Customer profitability analysis

To make better decisions:
- choose its customer mix (higher proportion of profitable customers)
- determine an appropriate amount of after-sales service (CBA)
- introduce profitable products/services/customers, discontinue unprofitable product/service/customers
Customer cost analysis
Unit-level cost: resources consumed for each unit sold
Sales commission/unit
Freight charge/unit
Batch-level cost: resources consumed for each sales transaction
Order processing costs
Invoicing costs
Sales return costs/order
Delivery costs (from warehouse to customer)
Customer-sustaining cost: resources consumed to service a customer regardless of the number of
units/batches sold
Cost per customer visit
Collection costs
Distribution channel cost: Resources consumed in each distribution channel used
Warehousing costs
Transport costs from factory to warehouse
Sales-sustaining cost: resources consumed to sustain sales and service activities that cannot be traced
to an individual unit, batch, customer or distribution channel
Advertising costs (in general)
Salary of General Manager
 Customer Lifetime value: NPV of estimated future profits from the customer.

Porter’s 5 forces
Threat of New Supplier Power *Competitive Threat of Buyer Power
Entry Rivalry Substitution
Time and cost of Number of suppliers Number of Competitors’ ability Number of customers
entry competitors to substitute
performance
Specialist knowledge Size of suppliers Quality differences Cost of change Size of each order
(bargaining power)
Economies of Scale Uniqueness of service Switching costs Differences between
competitors
Cost advantages Ability to substitute Customer loyalty Price sensitivity
suppliers
Technology Cost of changing Ability to substitute
protection
Barriers to Entry Cost of changing

Seminar 3
Cost planning
Upstream costs: before manufacturing
Downstream costs: after manufacturing

Cost Life Cycle

- Research and Development (RandD)
- Design
- Manufacturing (or providing the service)
- Marketing/distribution
- Customer service

Sales Life Cycle

- Introduction of product/service to the market
- Growth in sales
- Maturity
- Decline
- Withdrawal from the market

Target Costing – steps (used during design and manufacturing phase)

1. Determine the market/competitive price (how much customers are willing to pay)
2. Determine the desired profit
3. Determine the target cost = competitive price – desired profit
4. Use value engineering and Kaizen costing to identify ways to reduce product cost
 Value engineering: analysis of the trade-offs between different types of product functionality/features and
total product costs
- Functional analysis: analysis of each major function/feature of the product (for products with
many features)
- Design analysis: analysis of each possible design with different levels of performance and cost
(for industrial and specialized products)
- Group technology/design: method of identifying similarities in parts of products manufactured so
the same part can be used in two or more products to reap Economies of Scale (for multiple
products)
- Concurrent/simultaneous engineering: method that integrates product design with
manufacturing and marketing throughout the product’s life cycle through cross-functional teams
which receive and apply information at each phase of the value chain (for complex products)
5. Use kaizen costing and operational control to further reduce costs
Kaizen costing: ongoing search to reduce costs in a manufacturing process of a product with a given design
and functionality
- Develop new manufacturing methods
- Use new manufacturing techniques:
 Operational Control: Analysis of actual operating income with budgeted operating income
and the variances
 Total Quality Management: unyielding and continuous effort by everyone in the
organization to understand, meet, and exceed the expectations of customers
 Theory of Constraints: focusing effort on improving efficiency at activities that were
constraints (bottlenecks)
o Identify the constraint
o Determine the most profitable product mix given the constraint
o Maximise the flow through the constraint
o Add capacity to the constraint
o Redesign the manufacturing process for flexibility and fast cycle time

Target Costing - benefits

- Customer-focused (based on customer value)
- Reduces costs, through more effective and efficient design
- Helps firms achieve desired profitability on new or redesigned products
- Can decrease the total time required for product development, through improved coordination of design,
manufacturing, and marketing functions
- Can increase communication and cooperation among departments
- Can improve overall product quality, as the design is carefully developed and manufacturing issues are
considered explicitly in the design phase (early stage)

Target Costing - drawbacks

- Need to develop detailed cost data
- Time demands associated with cooperation and coordination throughout the organisation

Life-cycle Costing
Life-cycle costing provides a long-term perspective because it considers the entire cost life cycle of the
product or service, which is especially important for products with high upstream (pharmaceuticals) or high
downstream costs (perfumes)
*under this costing method, importance of design/quality is emphasised

Strategic pricing
Long-term strategic pricing decisions not involving special orders or target costing/prices determined by
market

Introduction Growth Maturity Decline

Lack of competition Differentiated products Competitive quality and Cost control and
functionality effective distribution
network
Sales increases slowly Sales increases rapidly Sales volume peaks Sales decreases
 High price Lower price Even lower price Even lower price (lack of
(differentiated product + (competition increases, (competition intensifies, demand)
high costs) reduced costs) further reduced costs)
Losses due to high costs Increase in profits Profits start to decrease Profits decreasing

Strategic pricing - Pricing using the cost life cycle: eg skimming, penetration
- Full manufacturing cost plus markup
- Life-cycle cost plus mark up
- Full cost (manufacturing cost or life cycle cost) and desired gross margin percent
Full cost/Net income = 1 - gross margin percent
- Full cost (manufacturing cost or life cycle cost) plus desired return on assets
ROA = Net Income/Total Assets = Desired before-tax profits (1-T)/Total Assets
Price = Full cost + Desired before-tax profits, or
Price = Full cost x markup rate = full cost x (Operating asset x ROA/full cost)

Cost Volume Profit (CVP) Analysis

CVP (Cost-Volume-Profit) analysis is a method for analysing how various operating and marketing decisions
affect short-term profit

Cost Volume Profit (CVP) Analysis - Applications

- Setting prices for products and services
- Deciding whether to introduce a new product or service
- Determining the desirability of replacing a piece of equipment
- Determining the breakeven point
- Deciding whether to make or buy a given product or service
- Determining the best product mix
- Performing strategic “what-if” analyses

Cost Volume Profit (CVP) Analysis - Strategic role

- To cost leadership firms: for identifying breakeven quantity
- To differentiated firms: for assessing the profitability and desirability of new products and features
- To target costing: show effect of alternative product designs on profit
- To life-cycle costing: identify the most cost-effective decisions (marketing etc)

Operating Profit = (Units sold x Selling price per unit) - (Units sold x Variable cost per unit) - Fixed Costs
B = (p x Q) – (v x Q) - F
(Total) CM = (p x Q) – (v x Q) = B + F
Change in CM = CM ratio x Change in (p x Q)
Unit CM = p – v = Total CM/Q = increase in operating profit for a unit increase in sales
CM ratio = CM/(p x Q) = Unit CM/p = (p – v)/p
CM ratio + Variable expense ratio = 1
Weighted-average CM = CMA x sales mixA (in units) + CMB x sales mixB (in units) = increase in operating
profit for a bundle of unit increase in sales
Weighted-average CM ratio = CM ratioA x sales mixA (in dollars) + CM ratioB x sales mixB (in dollars) =
Total CM/Total sales = proportion of each sales dollar that is available for the recovery of fixed costs
Breakeven Quantity (no taxes)= F/(p – v) = F/Unit CM
Breakeven Quantity (with taxes)= [F + (A/(1-T))]/(p – v) = [F + (A/(1-T))]/Unit CM
Breakeven amount (in sales dollars, no taxes) = F/[(p – v)/p] = F/CM ratio
Breakeven amount (in sales dollars, with taxes) = [F + (A/(1-T))]/[(p – v)/p] = [F + (A/(1-T))]/CM
ratio
Indifference point Q between fixed and variable costs: FA + (vA x Q) = FB + (vB x Q)


Contribution Income Statement (to show CVP analysis)
Sales
Less: Variable Expenses
Contribution Margin
Less: Fixed Expenses
Net Income

Sensitivity Analysis
a tool that budget planners use to determine the extent to which a change in the forecasted value of one or
more budgetary inputs affects individual budgets and the set of pro forma financial statements produced as part
of the master budgeting process
- What-if Analysis: calculation of an amount (eg operating profit) given different levels of a factor that
influences that amount (eg variable cost per unit)
- Decision Tables/Decision Trees/Expected Value Analysis: probability of each possible event is estimated
to arrive at the expected value of each decision alternative
- Monte Carlo Simulation: resampling values of factors in a model based on the probability density
functions for each input variable in the CVP model, in order to generate a probability distribution of
outcomes
- Margin of Safety (MOS): dollar amount of planned (or actual) sales above the breakeven point = Sales –
Breakeven sales
Margin of safety ratio (MOS%) = MOS/Sales = (Sales – Breakeven sales)/Sales = the % that sales could
fall before losses occur
- Operating Leverage: refers to the extent of fixed costs in an organization’s cost structure (greater
proportion of fixed costs > greater Operating Leverage > Greater operating risk of not being able to cover
fixed costs)
Degree of Operating Leverage = CM/Operating profit = [Sales – Variable costs]/[Sales – Variable Costs –
Fixed Costs] = sensitivity of operating income to changes in the sales volume

Seminar 4
Relevant cost/Avoidable cost/Differential cost: future cost that differs between decision alternatives (can be
variable or fixed) > may include opportunity costs: the benefit forgone when one chosen option precludes the
benefits from an alternative option (eg lack of capacity or market cannibalism)
Sunk cost: cost incurred in the past/committed cost (unavoidable) > Irrelevant
Allocated cost/unavoidable cost > Irrelevant
Depreciation: sunk cost > Irrelevant (unless tax implications are considered)
Fixed cost: can be a sunk cost or a relevant cost (if can be changed in the short run)
Indifference point Q between fixed and variable costs of decisions: F A + (vA x Q) = FB + (vB x Q)
*Relevant cost analysis and total cost analysis will produce the same decision

Strategic cost analysis

Relevant cost analysis Strategic analysis
Short-term focus Long-term focus
Not necessarily linked to firm’s strategy Linked to firm’s strategy
Product cost focus Customer focus
Focused on individual product or decision situation Integrative consideration of all customer factors

5 steps in the decision-making process

1. Identify the decision problem (what decision is needed)
2. Determine the decision alternatives (what are the possible decisions)
3. Evaluate the costs and benefits (total or relevant analysis) of the alternatives (differential analysis)
If resources are limited, consider opportunity costs: cost of forgone benefits
Option 1 Option 2 Difference
Relevant or total revenue
Relevant or total cost
Total
4. Make the decision (including non-financial analysis)
5. Review the results of the decision (for future decisions)

Special order decisions

1. Identify the decision problem (accept special order?)
 2. Determine the decision alternatives (accept or not accept)
3. Evaluate the costs and benefits (total or relevant analysis) of the alternatives (incremental analysis)
*If there is no sufficient spare capacity: consider opportunity costs
Opportunity cost per unit = total opportunity cost/number of units in special order
Accept special order if: Total CMspecial order – Opportunity cost of (lost sales) > 0

Accept special order

Relevant or total revenue Qlost sales (Unit CMoriginal)
Relevant or total cost
Eg opportunity cost of lost sales Qlost sales (Unit CMspecial order)
Total

4. Make the decision (including non-financial analysis)

- Ability to maintain pricing structure with existing customers (no erosion of normal pricing policies) >
only one-time opportunity
- Potential additional costs (production issues from special order, packaging costs, delivery costs, etc)
- Potential additional revenue (future partnerships or from additional publicity)
5. Review the results of the decision (for future decisions)

Make-or-buy/insourcing vs outsourcing decisions

1. Identify the decision problem (in-house production or outsource)
2. Determine the decision alternatives (in-house production or outsource)
3. Evaluate the costs and benefits (total or relevant analysis) of the alternatives (incremental analysis)
If cost is specific to the production: avoidable > include in incremental analysis
(assume) if cost is unavoidable > exclude from incremental analysis
If additional capacity has alternative uses > include in incremental analysis
Make Buy Difference
Relevant or total cost 1
Relevant or total cost 2
Less: profit from usage of additional - ( )
capacity
Total
4. Make the decision (including non-financial analysis)
- Reliability of vendor
- Quality of materials used by vendor
- Production capacity of vendor
- Whether outsourcing affects firm’s competitive position in the long-term (eg brand name)
- Potential alternative uses of plant capacity
5. Review the results of the decision (for future decisions)

Lease-or-purchase decisions
1. Identify the decision problem (indifference point between lease or buy?)
2. Determine the decision alternatives (lease or buy)
3. Evaluate the costs and benefits of the alternatives (incremental analysis)
Calculate indifference point Q = FA + (vA x Q) = FB + (vB x Q)
4. Make the decision (including non-financial analysis)
- Reliability of machine
- Quality of product produced by the machine
- Other benefits and features of the lease contract
5. Review the results of the decision (for future decisions)
Sell-or-process decisions
1. Identify the decision problem (sell now or process then sell)
2. Determine the decision alternatives (sell or process)
3. Evaluate the costs and benefits (total or relevant analysis) of the alternatives (incremental analysis)
If cost is specific to the production: avoidable > include in incremental analysis
(assume) if cost is unavoidable > exclude from incremental analysis
If additional capacity has alternative uses > include in incremental analysis
Sell Process Difference
Relevant or total revenue
Relevant or total cost
Less: profit from usage of additional - ( )
capacity
Total
4. Make the decision (including non-financial analysis)
- Whether processing will affect sales of non-processed products or vice-versa
- Potential additional costs (packaging costs, delivery costs, etc)
- Whether processing or not-processing affects firm’s competitive position in the long-term (eg brand
name)
5. Review the results of the decision (for future decisions)

Keep-or-drop decisions
1. Identify the decision problem (what decision is needed)
2. Determine the decision alternatives (what are the possible decisions)
3. Evaluate the costs and benefits (total or relevant analysis) of the alternatives (incremental analysis)
Keep segment Drop segment Difference
Relevant or total revenue
Relevant or total cost
Less: profit from usage of additional - ( )
capacity
Total

Even if a segment has a net operating loss, the company should keep the segment if the segment
margin (revenue less relevant costs) is positive (segment 2 is absorbing some of the common fixed
costs)
4. Make the decision (including non-financial analysis)
- Whether eliminating one segment would increase/decrease sales of another segment
- Whether eliminating one segment would lower employee morale due to layoffs
5. Review the results of the decision (for future decisions)

Constrained Optimisation Analysis - One production constraint

CM per unit
Units of limited resource required per unit of product
CM per unit per limited resource
> Assuming fixed cost is constant, focus on product with highest CM per unit of limited resource up to
expected demand, then next product with the next highest CM per unit of limited resource and so on
> If fixed cost is not constant, compare profitability of alternative solutions (for each set of situations with
the same fixed cost, select the highest CM per unit of limited resource and compare them) to focus on the
solution with the highest profits up to expected demand, then the solution with the next highest profits
and so on

Constrained Optimisation Analysis - Two or more production constraints

Units of A x Units of limited resource Y per unit of A + Units of B x Units of limited resource Y per unit of B =
Total units of limited resource Y available
For limited resource Y, Units of A = mY (Units of B) + cY

Units of A x Units of limited resource Z per unit of A + Units of B x Units of limited resource Z per unit of B =
Total units of limited resource Z available
For limited resource Z, Units of A = mZ (Units of B) + cZ

Compare Total CM = CM of A + CM of B if:

Units of A = 0, Units of B is maximum (lower or 36000 and expected demand)
Units of B = 0, Units of A is maximum (lower or 24000 and expected demand)
Intersection point between two graphs (4800, 20800)
- Equate mY (Units of B) + cY = mZ (Units of B) + cZ to find Units of B > then find Units of A

Constrained Optimisation Analysis - Behavioural and Implementation Issues

- Predatory pricing: a firm has set prices below average variable cost with a plan to raise prices later to
recover losses from these lower prices (drive out competitors) > is it lawful?
- Heavy focus on variable costs over fixed costs: lower management may be pressured to replace variable
costs with fixed costs at the firm’s expense

Seminar 5
Six Sigma Approach
Business-process improvement approach that focuses on characteristics that are critical to customers and
identifying and eliminating causes of errors or defects in processes

Six Sigma Approach - DMAIC

Define: define the problem, specify the deliverables of the project
Measure: collect relevant process-performance data
Analyse: uncover root causes of an underlying quality problem
Improve: generate and implement proposed solutions to the underlying problems(s)
Control: put appropriate controls into place to ensure that the identified problem does not recur

Six Sigma Approach – Implementation tips

- Provide necessary leadership and resources (employee training, appropriate buy-in for the concept)
- Implement a reward system (bonuses, incentive schemes)
- Provide ongoing training
- Judiciously select early projects (easy, non-political, noncontroversial)
- Break up difficult projects (various milestones)
- Avoid employee layoffs (judicious job reassignment)

Setting Quality Expectations – Goalpost Conformance

Quality specification expressed as a specified range around the targeted performance level
Assumption: quality-related costs do not depend on the actual value of the quality characteristic, as long as it is
within the specified range

Setting Quality Expectations – Absolute Quality Conformance

Quality specification expressed as a specified target value exactly, with no variation
Assumption: the smaller the departure from the target value, the better the quality

Setting Quality Expectations – Goalpost Conformance vs Absolute Quality Conformance

For long-term profitability and customer satisfaction, absolute conformance may be he etter approach

Setting Quality Expectations – Absolute Quality Conformance – Taguchi Quality Loss Function
Depicts the relationship between quality costs and level of deviation from target quality

L(x) = loss from having an observed quality characteristic x

x = observed value of quality characteristic
T = target value of quality characteristic
k = cost co-efficient, determined by the firms cost of failure

Total quality cost = prevention costs + internal failure costs + appraisal costs + external failure costs

EL(x) = expected (average) loss from having a quality characteristic equal to x

σ2 = variance of the quality characteristic x about the target value
D = the deviation of the mean value of the quality characteristic from the target value = x̄ - T
 Cost-of-Quality (COQ) reporting
Cost of activities associated with the prevention, identification, repair, and rectification of poor quality, as well
as opportunity costs from lost production and lost sales as a result of poor quality
*Activity-Based Costing (ABC) supports COQ reporting

Cost-of-Quality (COQ) reporting – purpose

- Awareness: make management aware of the magnitude of COQ
- Motivation: encourage continuous improvement in COQ
- Measurement: provide baseline against which the impact of quality-improvement investments
*express relative to baseline amount such as net sales or total operating costs (%)

Cost-of-Quality (COQ) - Least to most expensive

Prevention costs Appraisal costs Internal failure costs External failure costs
(Prevention costs) (Detection costs during (Detection costs before delivery to (Detection costs after delivery to
Incurred to keep production) Incurred to customers) Associated with customers) Associated with
quality defects from measure and analyse data to defective processes or defective defective processes or defective
occurring determine conformity of products products
outputs to specifications
Conformance costs Nonconformance costs
Incurred to ensure products meet customer Incurred due to poor-quality products (include opportunity costs)
expectations
Quality training costs Inspection costs (of raw Costs of corrective action (eg cost Costs to handle customer
materials, work-in-process, to find and correct cause of failure) complaints and returns (eg
finished goods, machinery) salaries and admin costs of
customer service department)
Costs of planning and Test equipment costs (eg Scrap disposal (net cost) Sales returns and allowances +
execution of a quality depreciation, salaries, freight charges
program (eg quality maintenance, software)
circles)
Investments (eg Rework costs (eg materials, labour, Repair or replacement costs (eg
product redesign, overheads) warranty costs/field service costs)
process improvement)
Supplier-assurance Opportunity costs (eg loss due to Opportunity costs (CM of
costs (costs of downgrades, lost production due to cancelled sales orders, CM of lost
selection, evaluation work interruptions, CM lost from sales orders, market share)
and training of units not produced because of
suppliers) unavailability of constrained
resources)
Equipment Expediting costs (eg cost to Product recall costs
maintenance costs expedite manufacturing operations
due to time spent on repair or
rework)
Information systems Reinspection and retest costs Product liability lawsuit costs
costs
Process costs (eg costs to redesign Costs to restore reputation (eg
the product or processes) marketing costs)

Cost-of-Quality (COQ) – Nonfinancial Quality Indicators examples

Internal Nonfinancial Quality Indicators External Nonfinancial Quality Indicators

> usually process efficiency measures
Process yield
Productivity
Percentage of first-pass yields
Number of defective parts produced
Number of defective units shipped to customers as a
percentage of total units shipped
Number of customer complaints
Customer loyalty (eg repeat purchases, customer
retention rates)
Percentage of products that experience early or
excessive failures
 Machine up-time/downtime Delivery days (difference between scheduled
delivery date and date requested by the customer)
Trend in dollar amount of inventory held On-time delivery rate
Employee turnover Customer-satisfaction survey
Safety record (eg number of days since last accident) Customer-response time (total lapse time between
when a customer places an order and when the
customer actually receives the completed goods)
Throughput (outputs delivered) Net promoter score (difference between the
percentage of “promoters” and “detractors”)
Production lead time (difference between when an
order is received by manufacturing and when that
order is complete)
Cycle-time efficiency/throughput time ratio (ratio of
time spent on value-added activities to the sum of
time spent on value-added and non-value-added
activities)
Throughput efficiency (ratio of throughput to
resources used)
New product development time

Cost-of-Quality (COQ) – Role of Nonfinancial Quality Indicators

- Mostly readily available (less costly to obtain)
- Relevant to operating personnel (understandable)
- Focus attention on precise problems that need attention
- More timely then financial quality indicators, even real-time
- Useful predictor of future financial performance

Detecting and Correcting Poor Quality – control charts

Plots successive observations of an operation or cost taken at constant intervals

Detecting and Correcting Poor Quality – run charts

Control charts with constant intervals of time

Detecting and Correcting Poor Quality – statistical quality control (SQC) or statistics process control
(SPC) charts
Control charts with the central line and the limits determined through a statistical process

Taking Corrective Action – histograms

Graphical representation of the frequency of attributes or events in a given set of data
Taking Corrective Action – Pareto charts
Histograms of factors contributing to a specified quality problem, ordered from the most to the least frequently
occurring factor

Taking Corrective Action – cause-and-effect/”fish-bone” diagrams

Organisation of a chain of causes (4Ms) and effects to sort out root causes of an identified quality problem

Lean Manufacturing
Reconfiguration of the manufacturing process to increase product flow and product quality, reduce inventories,
improve decision making and enhance profitability

Lean Manufacturing – vs Traditional Production

Lean Manufacturing – Lean Accounting
Usage of value streams to measure the financial benefits of a firm’s progress in implementing lean
manufacturing > to better understand the profitability of its process improvements and product groups rather
quickly

Lean Manufacturing – Lean Accounting vs Traditional Costing

Seminar 6
Long-term objectives - Capital budgeting and Strategic budget expenditures
Capital budgeting: Process for evaluating, selecting and financing long-term projects and programs
Strategic budget expenditures: planned spending on initiatives and projects that lead to long-term value and
competitive advantage for the organisation

Short-term objectives – Master budget (operating budgets and financial budgets)

Operating budgets: plans that identify resources needed to implement strategic projects and to carry out
budgeted activities (customer service, production, purchasing, personnel, marketing)
> culminates in a budgeted income statement
Financial budgets: plans that identify sources and uses of funds for budgeted operations and capital
expenditures
> culminates in a budgeted balance sheet

Alternative Budgeting Approaches

- Zero–Base Budgeting (ZBB): a budgeting process that requires managers to prepare budgets each period
from a zero base
- Activity-Based Budgeting (ABB): is an extension of the traditional form of activity-based costing
- Time-Driven Activity–Based Budgeting: is a method of budget preparation used in conjunction with a
TDABC system
- Kaizen (Continuous–Improvement) Budgeting: a budgeting approach that incorporates continuous–
improvement expectations in the budget
Behavioural issues in Budgeting
- Budgetary Slack: a “cushion” managers intentionally build into budgets to help ensure success in meeting
the budget (usually when compensation is tied to meeting budgets)
- Goal incongruence: inconsistency between the goals of the firm, its subunits, and its employees.
- Authoritative vs Participative budgeting

Master budget - manufacturer

*Merchandiser’s budget has Purchases budget instead of Production budget, Direct Materials budgets, Direct
Labour budget Factory overhead budget

Master budget – Sales budget

Budgeted sales (in units)
Selling price
Sales Revenue

Master budget – Production budget

Budgeted sales (in units)
Desired ending inventory (in units)
Desired beginning inventory (in units)
Budgeted production (in units) = Budgeted sales (in units) + Desired ending inventory (in units) - Desired
beginning inventory (in units)

Master budget – Direct materials usage budget

Budgeted production (in units)
Direct materials needed per unit (in units)
Total direct materials needed (in units)

Cost per unit of direct materials (in $)

OR
Cost of direct materials in beginning inventory (in $)
Cost of direct materials purchased (in $)
Cost of direct materials in ending inventory (in $)

Total cost of direct materials used

Master budget – Direct materials purchases budget

Total direct materials needed (in units)
Desired direct materials ending inventory (in units)
Desired direct materials beginning inventory (in units)
Total direct materials purchases (in units) = Total direct materials needed (in units) + Desired direct materials
ending inventory (in units) - Desired direct materials beginning inventory (in units)
Purchase price per unit of direct material
Total cost of direct materials purchases

Master budget – Direct labour budget (for each class of labour)

Budgeted production (in units)
Direct labour-hours per unit
Total direct labour-hours needed
Cost per direct labour-hour
Total cost of direct labour

Master budget – Factory overhead budget

Total (direct labour-hours/machine-hours)
Total variable factory overhead
Total fixed factory overhead
Total factory overhead = Total variable factory overhead - Total fixed factory overhead
Less: non-cash expenses (eg depreciation)
Cash disbursements for factory overhead

Master budget – COGM and COGS budget

Total cost of direct materials used
Total cost of direct labour
Total factory overhead
Total COGM = Total cost of direct materials used+ Total cost of direct labour + Total factory overhead
Less: finished goods ending inventory
COGS

Master budget – Selling and administrative budget

Selling expenses
Administrative expenses
Total selling and administrative expenses
Less: non cash expenses (eg bad debts expense, depreciation)
Cash disbursements for selling and administrative expenses

Master budget – Cash receipts budget

Sales Revenue
Cash sales (including credit card sales)
Credit sales

Cash received from cash sales (from current month sales)

Cash received from cash sales (from prior month(s) sales)
Cash received from credit sales (from current month sales)
Cash received from credit sales (from prior month(s) sales)
Total cash receipts

Master budget – Cash budget

Cash balance, beginning
Cash flow from operating activities
Total cash receipts
Less: cash paid for direct materials
Less: cash paid for direct labour
Less: cash paid for factory overhead
Less: cash paid for selling and administrative expenses
Net cash flows from operating activities

Cash flow from investing activities

Cash received/paid for equipment
Net cash flows from investing activities

Cash flow from financing activities

Cash received from bank borrowing
Cash paid for repayment of borrowings
Cash paid for interest
Net cash flows from financing activities

Cash balance, ending

Master budget – Budgeted balance sheet

Gross sales revenue
Less: sales allowances and returns
Net sales revenue
Less: COGS
Gross profit
Less: selling and administrative expenses
Net operating income
Less: interest expense
Income before income taxes
Less: income taxes
Net income

Operating-Income Variances (Single Product, excluding sales mix)

Flexible budget
Budget that adjusts revenues and expenses to the actual output level and sales mix achieved, prepared at the end
of a period
A type of pro forma budget based on actual activity level: budget prepared for multiple output levels

Flexible budget - steps

 1. Determine the output of the period (in units)
2a. Calculate the selling price and the variable cost per unit from the master budget
2b. Calculate the flexible-budget sales revenue and flexible-budget variable expenses for the output of the
period
2c. Calculate the flexible budget CM = flexible-budget sales revenue – flexible-budget variable expenses
3a. Calculate the budgeted fixed costs
3b. Calculate the flexible-budget operating income

Flexible budget – outline

Units
Selling price
Sales
Unit variable expenses
Variable expenses
Unit CM
Total CM
(Unit fixed expenses)
Fixed expenses
Operating income

Standard Costing – Standard Costs

Costs that should be incurred under efficient operating conditions
*Promotes cost control through use of variance analysis and performance reports
Standard Costing – Standard Cost System
Cost system in which standard, not actual, cost flow through the formal accounting records
Standard Costing – Types of Standards
- Ideal standards: reflect maximum efficiency in every aspect of the operation
- Continuous Improvement standard: one that gets progressively tighter over time
- Currently attainable standard: sets performance expectations at a level that a person with proper training
and experience can attain most of the time without having to exert extraordinary effort
Standard Costing – Standard-Setting Process
- Authoritative standards: determined solely or primarily by management
- Participative standards: calls for active participation through the standard setting process by employees
affected by the standard > individuals most familiar with the variables associated with standard-setting to
provide the most accurate information

Types of Variances
Actual Flexible-budget variances Flexible Sales Master
budget volume budget
variances
Units
Selling
price
Sales Selling/Sales price variance Sales
revenue volume
variance
Sales variance

Direct Direct materials variances*

materials Direct materials price Direct materials usage
variance variance
Direct Direct labour variances*
labour Direct labour rate variance Direct labour efficiency
variance
Factory Factory overhead variance*
Overhead
Selling and Selling and admin expense variances
Admin Fixed selling and admin Variable selling and admin
expenses expense variances expense variances
Operating Total operating income variance
income Total flexible budget variance Sales
volume
variance
*Manufacturing cost variances = Total direct materials flexible-budget variance + Total direct labour flexible-
budgeted variance + Total factory overhead variances (fixed and variable)

Decomposition of Variable Cost Variances

Interpretation: (purchasing department)

Even if F > could be due to poor quality materials
Hurt differentiation strategy: poor quality materials
Hurt low cost strategy: excessively high manufacturing costs such as scrap, rework, repair and
replacement costs
*Materials purchase-price variance: use Total number of units of the direct material purchased

Interpretation: (production department)

U > could be due to variation in the quality of direct materials, inadequate training, inexperienced
employees, poor supervision etc

Interpretation: (personnel department/production department)

 U > could be due to not using workers with the skill level specified in the standard cost sheet for the work
performed or an outdated standard

Interpretation: (production department)

U > could be due to employees’ inefficiency in carrying out their tasks, inadequate training, employees’
skill levels are different from those specified in the standard cost sheet, batch sizes are different from the
standard size, materials are different from those specified, equipment are not in proper working
condition, poor scheduling

Decomposition of Manufacturing Overhead Variances

Flexible-budget Flexible-budget
based on inputs based on outputs

Actual input Actual input Flexible-budget

cost at Standard Amount
Cost
AQ x AP AQ x SP SQ x SP
Variable Variable Variable
overheads overhead overhead
spending efficiency
variance variance*

Actual cost Budgeted cost Standard

overhead cost
applied
Actual FOH Budgeted FOH SQ x Standard
(lump-sum) (lump-sum) FOH rate
Fixed Production-
overheads Fixed overhead spending variance volume
(denominator)
variance
Total Total overhead flexible-budget variance Production-
overheads volume
variance*
Total overhead cost variance

For VOH, same model used for cost control and product-costing purposes
VOH spending variance = [Actual VOH per DLH – Budgeted VOH per DLH] x Total DLHs

VOH efficiency variance = [Actual DLHs – Budgeted DLHs] x Budgeted VOH per DLH
Interpretation:
F/U Variable overhead efficiency variance reflects selected activity measure’s efficiency variance (does
not reflect overhead control)

For FOH, different models used for cost control (lump sum) and product-costing purposes (treated as
variable costs)
FOH spending variance = Actual FOH – Budgeted FOH

Production-volume (denominator) variance = Budgeted FOH - Total standard DLHs allowed for the output of the period
x Budgeted FOH per DLH
= Budgeted FOH per DLH x (Actual DLHs during the period – Total standard DLHs allowed for the output of the
period)
Interpretation:
 F/U Production volume variance results from operating at a level other than the denominator volume
level, reflects usage of capacity (for product-costing purposes, not for control purposes)
Fixed Overhead Application Rate – steps
1. Determine the total budgeted FOH for the upcoming period
2. Select an activity variable for applying FOH to outputs (eg DLHs, MHs)
3. Choose a denominator volume level for the selected activity variable
Supply-based:
- Theoretical capacity (maximum level of activity at 100% efficiency)
- Practical capacity (theoretical capacity reduced by normal output losses)
Demand-based:
- Budgeted capacity (planned/forecasted output for the upcoming period)
- Normal capacity (expected average demand per year over an intermediate-term, eg upcoming three
to five years)
4. Divide the amount in Step 1 by the amount in Step 3 to determin the standard FOH application rate for
product-costing purposes

Decomposition of Sales Variances

Weighted-average budgeted unit CM (WABUCM) = Total budgeted CM/Total budgeted units

Note: can be based on sales or CM

Actuals Flexible- Flexible- Flexible- Master
budget budget budget Budget
with with with actual
actual budgeted market
sales mix sales mix share
(Total) Actual Selling Actual Sales mix Actual Market Actual Market Budget
Units price variance share size
Selling Actual variance Budget Budget/ variance variance Budget/
price/ WABUCM WABUCM WABUCM
Unit
CM
Sales Actual Actual Budget Budget Budget
mix
Market Actual Actual Actual Budget Budget
share
Market Actual Actual Actual Actual Budget
size
Selling Sales mix Sales quantity variance
price variance
variance
Selling Sales volume variance
price
variance
Sales variance
Seminar 8
Performance measurement
Process whereby managers at all levels gain information about the performance of tasks within the firm and
judge that performance against pre-established criteria as set out in budgets, plans and goals
- Management control: refers to the evaluation of the performance of mid-level managers by upper-level
managers (focus on broader long-term strategic issues, management-by-objectives approach)
 Management-by-objectives: each mid-level manager is responsible for an area of responsibility
(strategic business unit or SBU)
 Strategic business unit (SBU): consists of a well-defined set of controllable operating activities over
which the SBU manager is responsible
- Operational control: refers to the evaluation of operating-level employees by mid-level managers (focus on
short-term performance issues, management-by-exception approach)

Management control – objectives (same as objectives of management compensation plans and objectives
of cost allocation)
- Motivate managers to exert a high-level of effort to achieve goals set by top management
- Provide the right incentive for managers to make decisions consistent with goals set by top management
(goal congruence)
- Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their
decision making

Management control – usually implemented through employment contracts

An agreement between the manager and top management designed to provide incentives for the manager to act
independently to achieve top management’s objectives
Issues in the principal-agent model:
- Uncertainty: managers operate in an environment that is influenced by factors beyond the manager’s
control
- Risk aversion: managers have different risk preferences (usually risk-adverse)
- Lack of observability: efforts and decisions of managers are not observable to the higher management,
manager possesses information not assessible to top management
Solutions to the issues (3 Principles of employment contracts)
1. Separate the performance of the manager from the performance of the SBU (Separate outcome of action
from effort and decision making skills of manager)
2. Exclude known uncontrollable factors from the contract
3. Separate the value of the outcome from the positive or negative weight associated with the risk due to
uncertainty
Management control – types of management control systems

- Who is interested in evaluating the organization’s performance (owners, directors, creditors, employees,
etc.)?
- What is being evaluated (an individual, team, or SBU)?
- When is the performance evaluation to be conducted?
 Should it be based on the master budget (resource inputs –ex ante) or the flexible budget (outputs
of the manager’s effort–ex post)?
 Which stage of the product life cycle is the product in?

- Should the system be formal or informal?

Strategic Performance Measurement

System used by top management to evaluate SBU managers
- Centralized: much of the decision-making at the top-management level
more control, top management and expertise can be effectively utilized, effective coordination and reduced
conflict between units
- Decentralized: a significant amount of responsibility is delegated to SBU managers
More timely decisions based on specialised local knowledge, more motivating for managers, better training
ground for future top-level managers, and can be better basis for performance evaluation (more objective)

Strategic Performance Measurement – SBUs - types

- Cost centers: are a firm’s production or support SBUs that are evaluated on basis of cost
Significant control over cost, but little control over revenues or investments
Measurement: costs for a fixed output, or output for a fixed input
- Revenue centers: defined by product line or by geographical area and focuses on selling function
Significant control over revenue, but little control over costs or investments
Measurement: (revenue drivers) factors that affect sales volume + quality of service (service firm)
- Profit centers: both generate revenue and incur major portion of costs for producing the revenue
Significant control over cost and revenue but little control over investments
Measurement: actual profits as compared to budgeted profits
- Investment centers: include assets employed by the SBU as well as profits in performance evaluation
Significant control over cost, revenue and investments
Measurement: ROI, RI, EVA
*Cost and revenue centers usually used when there is little need for coordination between the production and
selling units (eg cost leadership)
*Profit centers usually used when close coordination is needed between the production and selling units (eg
differentiation focus)
*Investment centers usually used when evaluation based on profits is insufficient as size of assets varies greatly
between profit centers

Strategic Performance Measurement – Controllability Principle

SBU managers are held responsible for decisions over which they have authority
*But no incentive to take actions that can affect the consequences of uncontrollable events eg storms, taxes

Cost Centers – strategic issues

- Cost shifting: replacing controllable costs (variable costs) with non-controllable costs (fixed costs) > need
top management to analyse and evaluate this shift
- Excessive short term focus: managers neglect long term strategic issues > use other financial measures (eg
overproduction to reduce average costs) and non-financial measures on costs (eg quality)
- Role of budgetary slack: budgetary slack > reduced manager effort, but also reduced risk aversion

Cost Centers – discretionary-cost approach vs engineered-cost approach

Discretionary-cost approach Engineered-cost approach
Cost mainly fixed, uncontrollable* Cost mainly variable, controllable*
Firms use an input-oriented planning focus Firms use an output-oriented evaluation focus
Outputs are ill-defined Outputs are well-defined
Focus is on planning (long-term goals) Focus is on evaluation (cost reduction)
*depends on whether costs are unit-level, batch-level, product-level or facility-level
*Marketing departments can be cost centers:
Order-getting costs: expenditures to advertise and promote the product (discretionary cost)
Order-filling costs: include freight, warehousing, packing and shipping, and collections (engineered cost)

Cost Centers – outsourcing

Advantages: reasonable cost, no risk of obsolescence, no potential management problems, access to new
technologies
Disadvantages: loss of control over a potentially strategic resource, dependence on other firm’s competence
and continued performance

Cost Centers – cost allocation – objectives (same as objectives of management control and objectives of
management compensation plans)
- Motivate managers to exert a high-level of effort to achieve goals set by top management
- Provide the right incentive for managers to make decisions consistent with goals set by top management
(goal congruence)
- Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their
decision making

Cost Centers – cost allocation – dual allocation

Cost allocation method that separates fixed and variable costs
Variable costs: directly traced to user departments
Fixed costs: allocated on some logical basis (eg ABC for indirect fixed costs)

Profit Centers – strategic role (better than revenue and cost centers)
- provide the incentive for the desired coordination among marketing, production, and support functions
- motivate cost center managers to consider their product as marketable to outside customers
- motivate managers to develop new ways to earn a profit from their products and services

Profit Centers – strategic issues

- setting appropriate transfer prices
- allocation of firm overhead costs to profit centers
- actions of a profit center may affect the profits of another profit center (interdependencies)

Investment Centers – Return on Investment (ROI)

Some measure of profit divided by some measure of investment in a business unit
Profit/Sales (Return on Sales or Profit Margin): measures the manager’s ability to control expenses and
increase revenue to increase profitability
*Profit = divisional operating income or net income after tax
Sales/Assets (Asset Turnover): measures the manager’s ability to increase sales from a given level of
investment
*Assets = average fixed assets and working capital
Investment Centers – Return on Investment (ROI) – measurement issues (relative performance)
- The same method/way of measuring income and investment
 Inventory cost flow assumption: FIFO/LIFO/WA
 Depreciation policy
 Capitalisation policy
- Measurement methods must be reasonable and fair to all business units eg the use of NBV will significantly
bias ROI measures to favour older units

Investment Centers – Return on Investment (ROI) – defining the ROI measure

Which assets to be included in ROI calculation?
- Fixed assets + working capital (usually average assets used)
- Working capital = current assets – current liabilities
- Only assets controllable at the business unit level should be included
- Value of intangibles may not be included
- Generally, value of leased assets should be included
- Idle assets should be included if they have an alternative use/are readily saleable/to encourage divestment of
idle assets

How to allocate shared investments?

- If untraceable, based on actual usage (use peak demand to allocate more assets to business units with higher
demand during certain periods)

How is investment measured?

- Historical cost: book value of current assets plus NBV of long-lived assets (commonly used, but different
ages of assets, depreciation policies and price changes since the purchase can make historical cost figures
irrelevant and misleading: illusion of profitability)
- Net Book Value (NBV): historical cost less accumulated depreciation
Measures of current value
- Gross Book Value: historical cost without any reduction for accumulated depreciation (usually used for an
objective, verifiable figure to remove the age bias)
- Replacement cost (purchase price): estimated cost to replace assets at current level of service and
functionality (usually used when the business unit is going concern)
- Liquidation value (exit value): amount that could be received from the sale of a business asset (usually
used in evaluating if the business unit is for potential disposal)

Investment Centers – Return on Investment (ROI) – strategic issues

- Value creation in the new (knowledge-based) economy: ROI measure may not capture value of
intangible assets such as human capital, innovative processes (use balanced scorecard as well)
- Short run focus of the metric: leads to manipulation of the numerator and denominator to reflect higher
ROI through illegal, unethical or myopic actions (use other performance indicators as well)
- Decision mode/and performance evaluation model inconsistency: investments evaluated on NPV, while
management performance evaluated on ROI (calculate depreciation for ROI purposes on a present-value
basis)
- Disincentive for new investment by the most profitable units: ROI encourages units to only invest in
projects that earn higher ROI than the unit’s current ROI, leading to a goal congruency problem (use
residual income)
 Advantages of ROI
Easily understood by managers
Comparable to interest rates and rates of return on
alternative investments
Widely used and reported in the business press
Disadvantages of ROI
Goal congruency issue: disincentive for business
units to invest in projects with ROI lower than the
unit’s current ROI but higher than the firms’ ROI
Comparability across investment centers can be
problematic

Investment Centers – Residual Income (RI)

Dollar amount equal to investment center income less an imputed charge for the level of investment in that
division
RI = Actual Income – (Minimum Rate of Return x Average level of investment in the unit)

Advantages of RI Disadvantages of RI
Supports incentive to accept all projects with ROI > Favours large units when minimum rate of return is
minimum rate of return low
Can use minimum rate of return to adjust for Not as intuitive as ROI
differences in risk
Can use different minimum rate of return for May be difficult to obtain a minimum rate of return
different types of assets at the business unit level

Advantages of both ROI and RI Disadvantages of both ROI and RI

Congruent with top management goals on
ROA/Invested Capital
Comprehensive financial measure that includes all
elements important to top management
Comparability: expands top management span of
control by allowing comparison across SBUs
May mislead strategic decision making; ie not as
comprehensive as BSC which is explicitly linked to
strategy
Accounting issues: variations exist in definition and
measurement of “investment” and in determination
of “profits”
Short term focus: neglects long-term benefits from
investments (use multi-period measure)
Failure to capture value-creating activities (eg
managing intangible assets)

Investment Centers – Economic Value Added (EVA)

Estimate of a business’s economic profit generated during a given period
EVA = Adjusted accounting net income of investment center - (Weighted average cost of capital x Level of
investment in the unit)
*If no adjustments made, EVA = RI

Sales
Less: operating expenses (Including tax)
Less: financing expenses (Weighted average cost of capital x Level of investment in the unit)
EVA

Investment Centers – Economic Value Added (EVA) - estimation

EVA
= Sales – operating expenses (including tax) – financing expenses
= NOPAT - (k x Average Invested Capital)
= (r-k) x Average Invested Capital
NOPAT= cash operating income after tax and after depreciation
= Revenue – Cash operating cost – Depreciation – Cash taxes on operating income
r = rate of return on capital = NOPAT ÷ Average invested Capital
k = minimum rate of return or hurdle rate = WACC
*Adjustments to “capital”: equity-equivalent adjustments (EE)

Investment Centers – Economic Value Added (EVA) – how to increase EVA

- Increase the efficiency of existing operations, and thus the spread between the investment return and the
firm’s weighted average cost of capital
- Increase the amount of capital invested in projects with positive spreads between investment return and
the firm’s weighted average cost of capital
- Withdraw capital from operations where the investment return is less than the firm’s weighted average
cost of capital

Advantages of EVA Disadvantages of EVA

Most relevant due to adjustments made (measures Less reliable due to estimations required
economic performance)

Seminar 9
Management compensation plans
Policies and procedures for compensating managers > recruiting, motivating, rewarding and retaining effective
managers is critical to the success of all firms

Management compensation – types

- Salary: fixed payment
- Bonus: variable payment based on achievement of performance goals for a period
- Benefits: perks such as club membership, life insurance, medical benefits, and other extras

Management compensation – strategic roles

- Strategic concerns facing the firm (as competitive strengths and weaknesses and critical success factors of
the firm change, the management compensation plan should change too)

- Effect of risk-aversion on managers’ decision making (balanced mix of salary and bonus in total
compensation)
- Certain ethical issues (high executive compensation may or may not be justified, compensation plans may
provide incentive for unethical behaviour eg to manipulate stock prices due to stock options)

Management compensation – objectives (same as objectives of management control and objectives of cost
allocation)
- Motivate managers to exert a high-level of effort to achieve goals set by top management (eg bonus plan in
line with firm’s profits)
- Provide the right incentive for managers to make decisions consistent with goals set by top management
(goal congruence) (eg rewards for developing firm’s critical success factors)
- Determine fairly the rewards earned by managers for their efforts and skill and the effectiveness of their
decision making (based on performance measures within the manager’s control, separate from the SBU’s
performance due to economic factors beyond the manager’s control, not based on relative performance to
other managers)

Bonus compensation (fastest growing element of total compensation and is often the largest part)
- Base of bonus compensation: select base to align managers’ incentives with those of the company
 Stock price (based on comparison with prior years/goals)
 Cost, revenue, profit or investment center-based performance (based on comparison with prior
years/goals/performance of other managers)
 Balanced scorecard (based on comparison with prior years/goals/performance of other managers)
*Based on comparison with prior years/goals: does not reflect change in economic situation of SBU
over time
*Based on comparison with performance of other managers: does not take into account different
economic situations of different SBUs

- Compensation pool:
 Own SBU (unit-based pool)
 Firm (firm-wide pool)

- Payment options:
 Current bonus (cash/stock): based on current performance (most common)
  Deferred bonus (cash/stock): earned currently but not paid for 2 or more years (to avoid/delay
taxes or to retain managers)
 Stock options: right to purchase stock at some future date at a predetermined stock price
 Performance shares: stocks given based on achieving performance goals over 2 years or more
*Use multiple measures (avoid manipulation) and longer-term payouts

- Other considerations:
 Tax effects (to reduce taxes for the firm, avoid taxes for the manager)
 Financial reporting effects
 Management compensation – service firms
Need to develop clear criteria and ranking of criteria

What do executives think about compensation?

- Fixed pay is better than substantially higher bonus (risk-adverse)
- Immediate value is better than deferred value (prefer simplicity, predictability)
- Fairness is essential (focus on relative compensation over absolute compensation)
- Willing to take a small cut in compensation for their ideal job (look beyond monetary considerations)
- Long-term incentive plans (valued for incentives and recognition)

Design recommendations for compensation schemes

- Performance pay has a cost (must have a clear purpose)
- Keep it short, sweet and simple (reduce complexity)
- One size doesn’t fit all (tailor compensation packages to different individuals)
- Money is only part of the deal (focus on non-financial incentives)
- How variable can pay actually be? (reasonable proportion of fixed pay)

Seminar 10
Transfer pricing
The determination of an exchange price for a product or service when different business units within a firm
exchange it (can be intermediate products or final products)
-> does not affect overall profit of firm

Transfer Pricing - Objectives

- To motivate a high level of effort on the part of business-unit managers -> by maintaining autonomy of
SBUs
- To achieve goal congruency -> eg to minimise income tax consequences of internal transfers of goods
and services
- To reward business-unit managers fairly for their effort, skill and effectiveness of decisions

Transfer Pricing - Methods

- Variable-cost method: sets the transfer price equal to the selling unit’s variable cost, with or without a
mark-up
- Full cost method: sets the transfer price equal to fixed and variable cost of the selling unit, with or
without a mark-up
- Market-price method: sets the transfer price as the current price of the product in the external market
(adjusted for cost savings from internal transfer eg selling costs)
o When the market for the intermediate product is perfectly competitive; and
o When interdependencies of subunits are minimal; and
o When there are no additional costs or benefits to the firm from buying or selling in the
external market instead of an internal transfer
- Negotiated-price method: involves a negotiation process and sometimes arbitration between units to
determine transfer price
*Dual pricing: involves the use of multiple prices for an internal transfer (buyer and seller)

Transfer Pricing – Methods - Advantages and Disadvantages

Advantages Disadvantages
Variable cost - encourages internal transfer if variable cost of - “unfair” to the selling unit because no profit on
selling unity is lower than the market price the transfer is recognised (if selling unit is a profit
(correct decision if selling unit has excess or investment center)
capacity, otherwise there are opportunity costs - inappropriate for long-term decision making (does
involved) not consider fixed costs)

Full cost - Easy to implement (data already exists for
financial reporting purposes)
- Intuitive and easily understood
- Preferred by tax authorities over variable cost
- Appropriate for long-term decision making
(considers fixed costs)
- Irrelevance of fixed costs in short-term decision
making (fixed costs should be ignored in decision)
- Selling unit has less incentive to control cost
(standard costs could be used instead of actual
costs)
Market price - Helps preserve autonomy of business units
- Provides incentive for the selling unit to be
competitive with outside suppliers
- Has arm’s length standard desired by
international taxing authorities
- usually provides for proper economic incentives
Negotiated - most practical approach when significant
price conflict exists
- consistent with the theory of decentralisation
Transfer Pricing – Methods - Criteria
Transfer Pricing – Methods - Selection
- Intermediate products often have no market
price
- Incorrect cost for pricing and other decisions of
buying unit
- Can lead to short-term sub-optimisation (eg
when selling unit has excess capacity)
- requires negotiation and/or arbitration
procedure, which can reduce autonomy
- not based on reasonable benchmarks
- not all managers understand their own
businesses, are co-operative, have the same
negotiating skills or are willing to put the firm’s
interests first (potential sub-optimisation)
- potential tax issues as negotiated transfer price
may not be arm’s length
- may be costly and time-consuming to implement
Transfer Pricing - General Transfer-Pricing Rule
Minimum transfer price = Incremental cost of the selling division up to the point of transfer + Opportunity cost
or maximum CM forgone by the selling unit by making an internal transfer (POV of selling division)
*May be hard to estimate
Maximum transfer price = market price, or if no market price, maximum transfer price = revenue – fixed costs
– other variable costs of buying division (POV of buying division)
*To obtain a range of transfer prices within which the profits of both divisions would increase

Transfer Pricing - International Issues

Arm’s–length standard: transfer pricing should be set so that they reflect the price that unrelated parties acting
independently would have set
- Comparable-price method: establishes the arm’s length price by using the sales prices of similar
products made by unrelated firms -> most commonly used, most preferred by tax authorities
- Resale-price method: establishes the arm’s length price based on an appropriate mark-up using gross
profits of the unrelated firm selling similar products -> when little value is added, no significant
manufacturing activities exist
- Cost-plus method: establishes the arm’s length price based on the selling unit’s cost + a gross profit
percentage determined by comparing the seller’s sales to those of unrelated parties
- Advance pricing agreements (APAs): agreements between IRAS and the firm using transfer prices
that establish an agreed-upon transfer price -> to save time and avoid costly litigation

Transfer Pricing – Other International Considerations

Minimization of total income taxes: higher transfer price if buying unit is in a country with higher income
taxes (high/low transfer prices depends on direction of flow)
Risk of expropriation: risk that government takes ownership and control of assets that a foreign investor has
invested in that country -> limit new investments/develop improved relationships with the foreign government
eg paying higher taxes via transfer-pricing decision (higher transfer prices)
Minimization of custom charges -> reduce tariffs and duties imposed on goods imported via transfer-pricing
decision (lower transfer prices)
Currency restrictions: problem arising in some countries that limit the amount and/or timing of repatriation of
profits to the parent company -> establish slow accumulation of profits vis transfer-pricing decision (high/low
transfer prices depends on direction of flow)
Seminar 11
Tools for strategy implementation
- Balanced Scorecard (BSC): accounting report that addresses an organization’s performance in four
perspectives > provides comprehensive performance measurement tool that reflects the measures (quantitative)
critical for the success of the firm (CSFs) + provide means for aligning performance measurement in the firm to
the firm’s strategic goals in the 4 perspectives (management translates strategy into performance measures for
employees)
 Financial perspective: financial measures (Has our financial performance improved?)
o Revenue growth: unit volume, annual revenue, a
o Productivity growth (cost reduction/asset utilisation): actual CM
 Customer perspective: customer satisfaction (Do customers realise that we are delivering more
value?)
o Market penetration: market share
o Customer retention and loyalty (relationship): % of repeat customers
o Customer acquisition: % of first-time customers
o Customer satisfaction (product/service attributes > addressing customer complaints):
customer satisfaction survey
o Customer profitability
o Brand image
 Internal process perspective: eg productivity and speed (Have we improved key business processes
so that we can deliver more value to customers?)
o Innovation: Percentage of sales from new products, new product introduction versus
competitors, product development break-even time
o Operations management: cycle time, quality, activity and process costs, post-sales service
processes, % of error-free orders
o Regulatory: compliance costs, legal costs
o Social
o Customer management
 Learning and growth perspective: eg training and number of new patents/products (Are we
maintaining our ability to change and improve?)
o Human capital: employee capabilities/training (training hours), employee
retention/satisfaction (employee satisfaction survey, peer review)
o Information capital: information systems
o Organisational capital: motivation, empowerment and alignment
- Strategy Map: method based on the balanced scorecard that links the four perspectives in a cause-and-effect
diagram > allow firm to develop and communicate strategy on achieving firm’s goals (achievement of goals in
one perspective leads to achievement of goals in another perspective, and to the overall success of the firm –
financial perspective)

BSC reflects strategy (cost leadership or differentiation)

- one should be able to infer a company’s strategy from its BSC
- cost leadership: focus on internal processes
- differentiation: focus on customer and learning and growth
- usually, indicator at the top has highest priority and so on

BSC - benefits
- Provides a means of tracking progress towards achievement of strategic goals (quantitative)
- Helps to draws managers to CSFs and rewarding them for achievement of these CSFs
- Helps to achieve a desired organizational change in strategy
- Provides a fair and objective basis for firms to use in determining manager’s compensation and advancement
- Coordination efforts within the firm to achieve CSF as BSC helps managers to see how activities contribute to
the success of others and motivates teamwork
- More accurate in difficult economic times, when traditional profit-based measures may be distorted and
difficult to benchmark against prior year/industry/competitor’s earnings

BSC – drawbacks
- may have a positive correlation between financial and non-financial measures (cause and effect)
- unable to monitor competitor’s actions
BSC - implementation
- Emphasis on continuous improvement over time and not just on attaining specific objectives
- Timeliness: review of BSC > feedback > change (loop)
- Financial measures are lag indicators that report on results of past actions
- Non-financial measures should be included > some (eg customer satisfaction) are leading indicators of future
financial performance
- Top managers are responsible for the financial measures; lower-level managers are in-charge of certain
activities and non-financial metrics

BSC – implementation issues

- BSC measures are only suitable for comparison to prior periods, and are difficult to compare across SBUs
- BSC is often used for strategic planning and performance evaluation, but less often in management
compensation but there is a need to link management compensation to performance evaluation
- Validation is needed of the links between measures that are assumed to improve performance
- Managers must be provided information on the strategic linkages in the strategy map for greater emphasis on
them
- Firms without Enterprise Resource Planning (ERP) systems may face difficulty collecting the necessary data
- The non-financial data used in the BSC is not subject to control or audit and may be unreliable to inaccurate
- Difference between cycles of preparation of non-financial information (weekly or daily basis) and performance
reviews (quarterly or annually) may complicate the nature and timing of reviews
- Non-financial data developed external to the firm may be untimely or unreliable

BSC – implementation steps

1 Develop a causal model to show the links between measures of performance and desired outcomes
2 Gather data to find out who maintains the non-financial data in the firm, with the objective of
improving the consistency and accuracy and accessibility of the data to decision makers
3 Turn the data into information by using regression analysis and other statistical tools, including
forecasting and other analytical tools, to test the validity of the model developed in Step 1 above
4 Continually refine the model by monitoring internal and external events and by rebuilding the
model on a timely basis
5 Base actions on findings. Have the confidence in the model to follow where it leads
6 Assess outcomes. Continuously assess the effectiveness of the model and the actions taken in Step
5 to produce the desired outcomes; does the model work?
Expansion of BSC – including sustainability
- firms are beginning to adopt the triple-bottom line: social, economic and environmental performance or
“people, planet and profits”
3 methods:
- Adding a 5th perspective to the BSC (usually)
- Developing a separate sustainability BSC
- Integrating sustainability measures into the 4 perspectives
> to delineate the relationship between sustainability objectives and outcomes with corporate strategy and
profitability

Economic indicators
Value created by the firm (including effect on profits of other firms)

Environmental Performance Indicators (EPIs)

 Operational indicators: fossil fuel use, toxic and non-toxic waste, pollutants (measure stressors)
 Management indicators: hours of environmental training (measure efforts to reduce)
 Environmental condition indicators: ambient air/water pollution concentrations (measure
environment quality)
Social Performance Indicators (SPIs)
 Working condition indicators: training hours, number of injuries (measure safety and opportunity)
 Community involvement indicators: employee volunteering (measure outreach)
 Philanthropy indicators: donations (measure direct contribution)
Expansion of BSC – including sustainability – Corporate Sustainability Model
Inputs to the model guide the decisions of leaders and the processes that the organisation undertakes to improve
its sustainability and usually are constraints that must be addressed:
- external context (regulatory and geographical)
- internal context (mission, strategy, structure and systems)
- business context (industry sector, customers, and products)
- human and financial resources available to the corporation

Expansion of BSC – including sustainability – measurement considerations

- There is an underlying objective for the measurement (measurement reflects important goal)
- Measurement terminology is defined and used consistently throughout the organization (comparability across
the organization)
- Information needed for the measurement is obtainable and reliable
- The measurement will create behavior that is in agreement with the organizational goals and objectives
- While there will likely be a combination of lagging and leading indicators, leading indicators are more
appropriate to help predict how the organization will perform in the future
- The measurements should be used to track performance trends (across time and across SBUs)
- Appropriate benchmarks and targets are set

BSC – typical question format

Identify CSFs + focus on which CSFs