acct2522 - notes

ACCT2522

MANAGEMENT ACCOUNTING 1

SEMESTER 1 2009 COURSE NOTES

Version 1.0.2 (10th June 2009)

kaheiyeh.web.officelive.com

Contents

Management Accounting 1 – Course Notes – Semester 1 2009 2

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Page 3: Understanding Processes and Value Creation

Page 8: Cost Basics

Page 15: Overhead Costs

Page 18: Activity Based Costing

1: Standard Costs and Variance Analysis

Page 24: Costing and Tactical Decisions

Page 28: Transfer Pricing

Page 32: Managing Quality

Page 36: The Theory of Constraints

Page 40: Capital Expenditure Decisions

Page 45: Performance Evaluation and Management Control

Management Accounting 1 – Course Notes

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First off, what is Management Accounting? It is defined by Langfield

“The processes and techniques that focus on the effective an

resources, to support managers in their tasks of enhancing both customer value and shareholder

From the above, we can see that resources are used in a variety of activities which lead to

processes which create customer and shareholder values. Graphically:

In this section, we will first only concentrate on processes and value creation.

Customer and Shareholder Value

So what are Customer Value

Customer Value is the value which a customer places on

service. The most important being cost, quality and time

Shareholder Value is the value that shareholders

things such as dividends, capital gains, profitability and revenue.

Elements of Value

In the above, we mentioned that cost, time and quality

important things that a customer places value on. So what exactly

• Cost

This means that processes must use as little resources as required to produce the product or

service.

• Quality

This is the degree to which the product or service meets the customer’s expectations.

• Time

The amount of time it takes for processes to occur and the on

business in all aspects.

We have to remember that these are all interrelated. If cost was reduced to a very low

amount, then quality certainly would not be good. Likewise, a high quality product may take a very

long time to produce and thus lower the firm’s timeliness.

Resources Activities

Understanding Processes and Value Creation

Course Notes – Semester 1 2009

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First off, what is Management Accounting? It is defined by Langfield-Smith as:

and techniques that focus on the effective and efficient use of organisational

, to support managers in their tasks of enhancing both customer value and shareholder

value.”


tomer and shareholder values. Graphically:


Value

So what are Customer Values and Shareholder Values?

is the value which a customer places on the features of

service. The most important being cost, quality and time (discussed below).

is the value that shareholders or owners place on the business based on

as dividends, capital gains, profitability and revenue.

oned that cost, time and quality (CTQ) were usually the most

important things that a customer places value on. So what exactly is in CTQ?

processes must use as little resources as required to produce the product or


The amount of time it takes for processes to occur and the on-time performance of the



hus lower the firm’s timeliness.

Activities ProcessesCreation


3

iioonn

Smith as:

d efficient use of organisational

, to support managers in their tasks of enhancing both customer value and shareholder



the features of a particular good or

place on the business based on

were usually the most

processes must use as little resources as required to produce the product or


performance of the



Value Creation



Resources

Resources are both the financial and non-financial items that an organisation uses to run the

business. Non-financial resources are usually used to determine the competency of a firm.

Examples of resources include cash and supplies.

Processes

A process is a group of activities that, when done together in sequential order, utilise the

firm’s resources to produce a result. From this, we can define an activity as a subset of a process. I.e.

A step in a process.

In the definition of a process, we stated that activities were done in a sequential order.

These activities are related to each other because the completion of one is required to start another.

A string of activities is separated by the points, where an output occurs or information is passed

along, into individual activities.

Processes can either be operational or administrative. To classify a process into either of

these categories requires knowledge of the firm and its context. An accountant filing a tax return for

a car manufacturer would be seen as an administrative process, where as an accountant that does

tax returns for clients would see this as an operational process.

Process Analysis

Four objectives are usually included in process analysis. These are:

1. Understanding

This process divides the business into processes and activities which makes it easier for

management to understand the structure and flow of the business. It becomes a lot easier

to see relationships between activities/processes and the links between them.

This is usually done with process mapping (discussed on the next page).

2. Monitoring

This objective involves continually monitoring processes and improving on them with

comparison to benchmarks and targets.

This is usually done by utilising Statistical Process Control (SPC; discussed later).

3. Prioritising

This process allows management to decide which processes are most critical to the

business’s survival and thus, allow them to most appropriately address issues in a timely

matter.

This usually achieved with the aid of a Pareto diagram (discussed later).

4. Problem Solving

Process analysis assists in problem solving by opening up and showing to management the

business’s processes. This means management now have a much clearer view of problems

and issues in each process.

Collectively, they are usually known as UMPP or UMPPS. A smart student should have noted

by now that process analysis is actually a process itself!



The first step is to identify the process of interest which is usually one that’s critical to the

business.

The next step is to chart the existing process. To do this, we must know some basics of

process charting.

These shapes are linked together with arrows showing the flow through the process.

This provides us with a graphical view of how a single process runs throughout the business.

This chart can further be divided into departments which allow managers to see which departments

need or do not need improvement.

The next step is to evaluate the process. Are the activities value adding or non-value adding

(NVA)? Are they efficient or effective? And are they valuable in terms of CTQ?

Value-Added and Non-Value-Added

A Value-added activity is one that provides value that is essential to the customer or is

essential to the survival and function of a business. To easily determine if something is value-added

or not we can simply ask ourselves three questions:

1. If it is taken away, is there a detrimental effect?

2. Is the customer prepared to pay for it?

3. Will it bring you one step closer to the finished product?

A Non-value-added activity is the opposite of a value-added activity in that it does not add

value to the product or service from anyone’s view.

It must be noted that not everything can be categorised as pure white (value-added) or pure

black (non-value-added). There are grey areas where a certain process/activity could be either. In

these situations, any answer is correct as long as you have evidence to back your point up.

Efficiency and Effectiveness

Efficiency is concerned with the use of minimal inputs to create the maximum amount of

output. Effectiveness is the ability of activities to meet the customer’s wants and needs.

There are tradeoffs between these two. Say if an employee produces high quality goods but

can only produce eight of these in one day, then he may not be meeting the business’s goals of

producing, say, fifteen per day. If a quota is demanded by the business for efficiency, then quality

(effectiveness) will be lost as the employee will not have as much time to work on the product.

In measuring efficiency and effectiveness, measures used must be comparable between

each other and be specific (I.e. a star rating and not a comment rating.).

Start/End Decision Activity



Value

In terms of CTQ, value is described in terms of cost, time and quality.

• Cost

Costs must be measured frequently and reduced as much as possible, but beware of the

consequences of reducing too much on efficiency and effectiveness.

• Quality

This should also be measured frequently but beware of the effects of reducing or increasing

this on costs and time.

• Time

Process, Waiting, Manufacturing, Inspection (PWMI) times should be kept to a minimum to

ensure timeliness.

Tools to evaluate the process

Generally, four approaches are used:

• Root Cause Analysis

This analysis looks at one, and only one, main reason why something happened.

• Fishbone Analysis

This analysis looks at a group of potential causes and the individual processes that caused

those main causes are also looked at.

See Exhibit 2.17 in BDMM Chapter 2, Page 53 for a diagram.

• Statistical Process Control (SPC)

A statistical process control is generally looking at something which varies between an upper

and lower control limit (3 standard deviations above and below the mean respectively), such

as the amount of water inside a water bottle varies and is not always the same. This assesses

the variations in the process and also allows management to address the causes of very

large variations above and below the limits.

• Pareto Diagrams

This diagram is based on the 80/20 theory where 20% of the population holds 80% of the

wealth in the world. This same theory is applied to Pareto Diagrams where small problems

account for a lot of the firm’s quality problems. These diagrams show the relative size of

problems encountered in a process. In this sense, it is a very useful prioritising tool for

management to use as it shows relative sizes.

Process Improvement

Processes can be improved by doing any of the following to activities:

• Activity Elimination

This means eliminating an activity altogether. Bear in mind that value-added activities

should not be removed and only non-value-added activities should be removed.

• Activity Selection

This means selecting the activity that costs the least for the same quality level.



• Activity Reduction

This means a reduction in the level of NVAs if they cannot be eliminated from the process.

• Activity Sharing

This means sharing activities across different products and services; such as the same engine

being used in a variety of different cars.

Processes can also be improved on a scale:

• Business Process Re-Engineering (BPR)

You could say this is CPR for a business to remember it easily. Basically the entire business’s

processes are reshuffled and changed in a massive one-off project to improve all processes.

• Continuous Improvement (CI)

This is a smaller scale, everyday, on-going improvement to processes. It involves everyone in

the business. Such as if an employee knows how to do something faster than others, they

could teach the other employees how to do so to maximise the timeliness.

It should be noted at BPR and CI are not mutually exclusive in that both can be done at the

same time. i.e. You could have BPR now to implement major changes and then continually improve

on that afterwards.

Processual and Functional Views of Organisations

A conventional view of a business is a functional view where the business is separated by

departments or functions (such as Finance, Purchasing, Production, Marketing, Quality etc.). This

view greatly restricts any change we try to bring in to the business as most processes flow through

many of these departments. As such, changing one department’s way of working in a process may

have no effect because the other departments in the same process are still working the old way.

A processual view of the company would be a much better option here where the business

is looked upon as processes instead of departments or functions.

Cost Basics


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Conventional vs. Contemporary Management Accounting

There have been major changes in management accounting and, as the chapter title

suggests, there has been a major change towards cost management.

In conventional management accounting systems:

• Costs are estimated and production volume is what varies cost.

• Budgets use planned revenues and costs or each department and then aggregated.

• Performance is measured financially only.

• Managers only focus on controlling costs (difference between actual and budgeted).

However, in contemporary management accounting systems:

• Costs are estimated based on individual activities in the business.

• Activity-based budgets are used (based around activities of course).

• Performance is measured based on critical success factors (quality, delivery and innovation).

• Managers are pro-active in that they not only control costs but also reduce them.

From this, we can see that a contemporary management accounting system is more

orientated to managing, controlling and reducing costs. This is the current view of management

accounting and is what we will be covering.

Costs

Costs are resources that a business has to use to achieve a certain objective. If the benefit

from it is used up in the process, it is considered an expense and if it is a benefit that carries into the

future, it is an asset. Note that this is simply capitalising or expensing a cost.

Cost Classification

Costs can be classified based on their:

• Behaviour patterns

• Traceability

• Controllability

• Value Chain

• Function

There are more classifications for costs but we will only cover the five listed above.

Cost Behaviour Patterns

Cost behaviour examines costs that arise as a result of increased activity. Before we examine

costs, we must note that they only apply over the relevant range (discussed in ACCT1511). They can

be:

Cost Basics


• Variable Costs

These costs are directly

affected by the level of activity

in the business. ie. Making

more products means more

cost.

• Fixed Costs

These costs are fixed and do

not vary with the level of

activity. Such an example

would be the rent of a factory.

• Step-Fixed Costs

These costs are fixed for a

certain level before moving up

to a new fixed level after a

certain amount of activity. An

example would be the cost of

internet; the price is fixed at

certain level of

bandwidth/speed but would

rise to a new level if the

business changed to a new

plan with higher

bandwidth/speed.

• Semi-Variable Costs

These costs have a fixed and

variable component in that

there is a base cost but any

activity after that increases

cost. An example is the phone

bill. There is base fixed rent for

the line while any calls on the

line increase cost.

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Total Costs Per Unit Cost

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Total Costs Per Unit Cost

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1 2 3 4

Step 1 Step 2 Step 3

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Cost Basics


• Curvilinear Costs

These are costs that are costly

per activity at first and at the

end, but level out over a

relevant range in the middle.

Such an example is a car. It

costs a lot to buy and have

initial inspections on a car but

the cost remains stable over its

life until it gets old, at which

costs will rise again. We

assume that the curve is linear

in the relevant range in the middle.

• Engineered costs

These costs have a defined physical relationship to the level of activity.

• Committed costs

These costs result from the organisations basic needs to survive (such as factory rent), and

are difficult to change in the short term.

• Discretionary costs

These result from managers deciding to spent a particular amount of money on a purpose

(such as for research and development).

Traceability

An important step is to be able to trace costs back to the cost object (the object which

generated those costs). For those costs that can be traced back to a cost object in an economic

manner, we call them direct costs (such as the cost of cans, water etc.). Those that cannot are called

indirect costs (such as factory rent, security).

Controllability

Managers in a business should only be held accountable for costs for which they have a

degree of control over. If managers are blamed for costs that they are not accountable for (that is,

they cannot control), then this can cause morale, communication and a whole slew of other

problems for the business as managers will end up getting angry at higher management.

Value Chain

Costs can also be split into each part of the value chain. Such as costs being attributed to:

• Research and Development

• Design

• Supply

• Manufacturing

• Marketing

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1 2 3 4 5 6 7 8 9 10 11 12

Cost Basics


Function

Function means looking at Manufacturing and Non-Manufacturing costs. This is similar to

traceability except that it involves a specific cost object.

• Direct Material

This is any raw material that is used in the production process, appears on the final product

and its cost can be traced back to a source economically. Some insignificant costs can fit the

criteria are labelled as indirect material because it would not be worthwhile setting up a

system to look at minor details.

• Direct Labour

This is any labour that used to produce the product or service.

• Manufacturing Overhead

This covers all costs other than direct material and direct labour costs. This means indirect

materials and indirect labour are seen as manufacturing overhead. It should be noted that

employee overtime is an overhead and not direct labour.

Direct material and direct labour can be known together as prime costs as major costs can

be directly associated with the product. Direct labour and manufacturing overhead, together, can be

known as conversion costs as this is the cost of converting raw materials to finished goods.

We can also look at costs based on how much it costs to produce a product. This is called

product costing. The cost of making the good is stored as inventory until it is sold, at which point, it

is moved over to the cost of goods sold account. Period costs are all costs that are not product costs.

Cost Behaviour and Cost Drivers

Cost behaviour is the relationship between cost and the level of activity that causes this cost.

In other words, it is the relationship between cost and its cost driver.

Cost drivers are the events that happen which cause costs to be incurred. For example: The

cost driver of shipping products would be the number of orders that the firm receives; the more

orders, the higher the shipping cost.

These can further be classified into four levels; known as the activity hierarchy:

• Unit Level Costs

Costs related to producing each individual product such as labour for each individual product.

• Batch Level Costs

Costs related to activities for a group of products such as the cost of a lecturer to a class

regardless of the amount of people attending.

• Product Level Costs

Costs related to specific products such as product designers.

• Facility Level Costs

Costs that are incurred as a result of activities needed to run the business such as factory

rent.

Cost drivers should be selected based on the costs and benefits of each driver.

Cost Basics


• Input or Output

Both inputs and outputs are cost drivers in a firm. To predict the best costs, we should be

applying the cost-benefit principle (in that the cost to obtain that information does not

exceed what it would generate in benefits). A problem with most firms is that they do not

have much time and usually select the most convenient cost driver with no regard to its

ability to best predict costs.

• The level of detail

Overall business costs must be separated down into smaller costs, but how far down do we

go? Once again, this is a cost-benefit problem and the level of detail depends on the

business.

• Timeframe

An accountant needs to be clear about the timeframe of the analysis and this mainly

depends on what the predicted costs will be used for. Costs that may be fixed in the short-

term may change in the long-term period. The timeframe for the analysis depends on the

reason for the analysis itself.

Cost Estimation

There are generally three ways to estimate costs. These are:

1. Managerial Judgment

2. Engineering Approach

3. Quantitative Analysis

Managerial Judgment

Managerial Judgment means simply using the managers’ experience and knowledge to

predict costs rather than using any formal analysis. Managers may also use the account

classification method where they look at ledgers and classify them into fixed, variable or semi-

variable costs.

Engineering Approach

This approach is generally a study of processes from input to output. Employees of the firm

may be subject to time and motion studies where they are observed doing their jobs. Steps required

and the time taken is all recorded down to find cost behaviours.

The advantage of this method is that it does not use past data as it is irrelevant and thus, is a

good choice for businesses that are just starting off and do not have significant past data to conduct

a more in-depth analysis. It is also cost effective if there is a direct relationship between input and

output.

However, if there is no direct relationship, it can be very costly. This approach is also very

dependent on employees as they are the primary object of study in this approach. If they were just

having a single bad day or a day where they managed to do very well, this would skew results.

Cost Basics


Employees are also wary of the fact that they are being monitored. They will usually work

abnormally faster than normal and/or go into a lot more detail than they usually do because they

are afraid that management might find out that they have been slacking off (if they have been).

Quantitative Analysis

This analysis uses past data to identify cost behaviour through:

• Scatter Diagrams

These diagrams are just points placed onto a graph. It allows us to visually assess cost

behaviour and also plainly see outliers. Outliers are usually as a result of error(s) or unusual

circumstances and should be eliminated from the cost analysis. Some judgment needs to be

used to identify the line of best fit though, which is the managers’ judgment.

• High-Low Method

This method only uses two data points; the one with the lowest level of activity and the one

with the highest level of activity. A line is drawn between these two points to find the cost

function. It is an easy and objective method that requires little data however, its accuracy

only holds in the relevant range and can be severely influenced if either of the two data

points are outliers.

• Regression Analysis

This is a statistical technique that estimates the relationship between a dependant (cost) and

an independent variable (Quantity of the cost driver).

It is advantageous to use this method because it is objective, accurate, complete and can

cover more than one cost driver. However, since this method is a statistical method, it can

be very costly to a business.

We evaluate a regression analysis by looking at:

1. Economic Plausibility: Does the output generated by the analysis fit economically with

the business?

2. Goodness of Fit: Is the R2 figure high? The higher R2 is, the more confident the analyst

can be about predicting costs as it means more variation in cost is explained by the cost

driver.

3. F-Statistic: This shows the likelihood that the relationship between cost and cost driver

happened by chance. Here, we want the p-value of the Significance F of the analysis to

be less than 0.05 to ensure this does not occur.

4. T-Statistic: This is similar to the F-Statistic except for each independent variable. We

look at the p-value of the independent variable and ensure that this is also less than 0.05.

Some assumptions we should know are that cost behaviours are linear within the relevant

range, but they may not be outside (we only look at the relevant range anyway). We also

need to know that cost behaviour depends on a single activity; except in the case of multiple

regression analysis.

Once again, the cost-benefit principle should be applied here.

Cost Basics


Issues with Cost Estimation

There are a range of problems that can be encountered with cost estimation:

• Data collection problems

We may have missing data, outliers, mismatched time periods, inflation and allocated fixed

costs just to name some problems. Collecting data requires skill and experience to sort

through and find relevant data.

• The learning curve

New employees take longer to do things and when they have stayed for a longer period of

time, will start doing things faster. This complicates the cost process.

• Cost-Benefit Principle

This has been discussed before but, how in depth and detailed should the analysis be? It

should only be up to a point where the benefits from that analysis will not be less than the

cost of the analysis.

• Gut Feeling

Many managers still prefer to use their gut feeling to do cost analysis because accountants

may not have the time or knowledge to do such an analysis, the data might not exist or low

priority is given to such analysis in the business.

Overhead Costs


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Recall from the last section that overhead costs are those that cannot be easily traced to

products and are allocated to cost objects. The question that we answer in this section is: How are

overhead costs allocated?

There are generally two types of overhead costs:

• Manufacturing

• Non-Manufacturing

General Principles

Groups of similar indirect costs can be put into cost pools. For example, all the computer

costs may be grouped together into a single cost pool. This simplifies the allocation process as we do

not have to allocate to as many cost objects.

It is always important for us to allocated overhead costs to products because without it, we

would not be able to have a reliable estimate of product costs.

Overhead Allocation Methods

There are three possible was to allocate costs of which we will discuss two (Activity Based

Costing is discussed in detail in the next section). These two are:

• Plantwide Rate

• Departmental Rate

Plantwide Rate

This is where a single overhead rate is applied to the entire plant. It is calculated in three

steps:

1. Identify the overhead cost driver (such as direct labour hours)

2. Calculate the overhead rate per unit of the cost driver

�� = ��

��

*Notice that we use the budgeted levels and not actual levels. Be careful!

3. Apply the above to the product based on how much of the cost driver is consumes

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Overhead Costs


Departmental Rate

This is similar to the plantwide rate except that we repeat it for each department (each

department may have a different cost driver!)

�� # �� = �� #

�� . #

Issues in Estimating Overhead Rates

Both the above rates use the budgeted figures and not actual figures. Thus, there will always

be a degree of estimation required. As usual, there is a trade-off between timeliness and accuracy.

You can spend more time on estimating and accuracy will increase but, spending less time means

less accuracy.

Plantwide rates can also distort decisions in that there might be products with unrealistically

low product costs, customers don’t complain about price rise and that some complex products may

seem like they are extremely profitable when in fact, they are not.

There are also issues in selecting the best plant rate. There must be a cost driver that is

common to all products and it must be able to be measured reliably and easily.

The effect of plant capacity also has an effect on estimating the amount of the cost driver

that will be used. We can base it on expected use (through normal budgeted volume: per year or

normal volume: per business cycle) or expected supply (practical capacity: assuming some

downtime or theoretical capacity: assuming maximum efficiency) of the cost driver.

Allocating Indirect Costs to Responsibility Centres

There are a lot of ways to allocate indirect costs to responsibility centres but its main goal is

to:

1. Allow managers of those sections to understand the economic effects of their actions.

Such as electricity overhead being split into sections; a manager would be able to see the

effects of increasing usage.

2. To encourage a set pattern of use.

Charging or not charging to use certain overheads means managers of sections will decide to

choose the most cost effective method and thereby, changing resource usage patterns.

3. To support product costing systems.

Allocation, in this case, is a side effect of introducing a product costing system where

overhead costs are allocated to departments.

Allocating Support Department Costs

We allocate support department (such as IT, HR, Accounting, Finance departments) costs to

user departments (such as machinery, assembly departments). This is usually done so that accurate

product costs can be developed.

There are two ways through which we can accomplish this:

Overhead Costs


Direct Method

This method allocated support department costs to the production departments only. It is

allocated to each department based on the ratio at which they use each support department’s

resource compared to the whole plant.

Example:

If $36800 of overhead costs are from electricity and the Moulding, Component and Assembly

departments use 360MW, 320MW and 120MW respectively, then overhead costs should be allocated

as follows:

Moulding Component Assembly

Allocated

Cost

Proportion Amount Proportion Amount Proportion Amount

$36800 360/800 $16560 320/800 $14720 120/800 $5520

Step-Down Method

This is exactly the same as the direct method except that the sequence in which overhead

costs are allocated from the department that serves the most other departments to the one that

serves the least. If there is a tie, the department that has the higher budget is given the higher

priority. This method also accounts for service departments using other service departments’

overhead whereas the direct method does not.

Reciprocal Method

This method relies on a set of equations, generated from data to find the costs that should

be allocated to each department. The equations need to be solved simultaneously to be able to find

the cost to be allocated.

Example:

Say if the materials department (M) has $20,000 worth of overhead and used 5% of quality

control’s (Q) overhead, then the equation would be:

M = 20,000 + 0.05Q

Which is the best method?

The best method depends on a few factors but should mostly be based on cost vs. benefits.

That is, do not spend more than what you would gain in savings from the method you choose.

Activity Based Costing


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Before we discuss Activity Based Costing (ABC), we first need to see the catalyst which

caused the change to ABC from conventional costing methods.

In a conventional costing system, Manufacturing Overhead is allocated to a volume driven

cost driver (such as machine hours or direct labour hours) which is then allocated to the product or

service. This method of allocation was, and still is, perfectly fine for companies who relied on heavy

manufacturing of a single or a few products.

Due to increases in globalisation, technology and competition, such a costing system is no

longer viable. These increases require more product diversity and complexity. The only way to

achieve this is for increases in non-manufacturing overhead such as research and development and

marketing costs.

Most of today’s costs are Non-Volume Driven and Non-Manufacturing. Thus, using a

conventional system would provide many issues. This is where ABC steps in.

The Activity Based Costing Model

The first step in the ABC model is to measure the costs of activities. By this we mean:

• Identifying resources

• Identifying resource drivers

• Identifying cost per resource driver

• Identifying activities

• Identifying resource drivers consumed by activity

Recall that resources are things that are consumed by activities. Examples include:

depreciation, advertising, salaries etc. Activities are units of work performed in the business and

include: advertising, manufacturing, servicing etc.

For example:

Resources Resource

Driver

Quantity of

Resource Driver

Cost Per

Resource

Depreciation $24,000 # of Assets 12 $2,000

Advertising $120,000 # of Ad Minutes 60 mins $2,000

Salaries $100,000 # of Employees 10 $1,000

Total Resources: $244,000



Then for activities:

Activity Pool Resource Usage Cost per

Resource

Activity Cost

Manufacturing

Computers

12 Machines $2,000 $24,000 $29,000

5 Employees $1,000 $5,000

Manufacturing

Set-up

3 Employees $1,000 $3,000 $3,000

Advertising 60 Ad Minutes $2,000 $120,000 $122,000

2 Employees $1,000 $2,000

Total Overhead Costs: $244,000

At this point, we must note that total Activity Costs should equal total Resources.

The next step is to allocate activities to products. This means:

• Identifying activity drivers

• Calculating the cost per activity driver

• Identifying activities consumed by the product

• Allocate the cost of activities to the product

Say in this example above, we produce 58 computers in 3 batch runs (meaning setting up 3

times) and spend all our 60 minutes advertising. We would get the following:

Activity Activity Driver Activity Level # of Activity Driver Cost per # of Activity

Driver

Manufacturing

Computers # Computers Unit 58 $500

Manufacturing

Set-up # Batches Batch 3 $1,000

Advertising # Ad mins Product 60 $2,033*

*Rounded off to the nearest whole number.

Now, say we had two products (a budget computer and a high performance computer). Let’s

say the budget computer used 2 batch runs, 30 minutes of advertising and we made 40 of them.

The total overhead to be applied to that product would be:

$500 x 40 + $1,000 x 2 + $2,033 x 30 = $82,990.

Since we made 40 of these, the total cost of each budget computer would be $2074.75.

Likewise, the cost of a high performance computer would be $3943.89.



The Activity Based Costing Decision

Now that we know how ABC works, should all firms adopt it? Seeing as it provides a more

accurate representation of costs, it seems hard to see why not.

However, only firms that have high non-manufacturing costs and most of their

manufacturing overhead are driven by non-volume drivers should use ABC. Firms that don’t have

significant non-manufacturing overhead and have most of their manufacturing overhead driven by

volume would see little difference in ABC. The costs of implementing and maintaining ABC may not

be viable for such firms in the latter category.

Issues with Activity Based Costing

Some behavioural issues will occur as with all changes in the business. This new system may

reduce the powers of managers; they may not like it and resist change. It is a good method to use

the bottom-up approach where employees learn of the benefits first before managers do to

influence them to change.

ABC is also costly and complex. Not many firms adopt it if they do not have the resources to

implement such a system. Some ABC methods also require that facility level costs be distributed to

products but such costs may have no obvious relationship to products. This means more time is

spent to find such a link.

Standard Costs and Variance Analysis


SSttaannddaarrdd CCoossttss aanndd VVaarriiaannccee AAnnaallyyssiiss

Controlling Costs

To control costs we must look at the following:

• The predetermined (or standard) level of costs

• The actual level of costs

• The comparison between the above two

Thus, the standard cost is the predetermined level of costs required to produce one single

good or service. Actual costs required to produce a single good or service are measured and then

compared with the standard cost. Any difference between the standard cost and the actual cost is

called a standard cost variance.

Setting the Standards

It’s all good knowing how it works but how do we get the standard cost in the first place? To

do this, we go looking at the firm’s historical data and also complete some time and motion studies.

We can also set our standards by:

• Asking lower level workers as they have more knowledge of what happens below. This is

known as Participative Standard Setting.

• Benchmarking against competitors. It must be noted that standard costs are not released in

all industries.

Types of Standards

There are two types of standards. These are:

• Perfection Standard

This standard presumes that the company gets low cost, high quality supplies, no sick

workers, no breakdowns and maximum efficiency. While this standard allows employees to

work towards a high goal, this goal may be impractical in that it is set too high. Employees

will then give up trying to reach that target. Product quality may also decrease as employees

try to cut time working on products to reach unrealistic goals.

• Practical Standard

This standard takes into account the fact that employees do get sick, that there are

breakdowns and supplied materials may not always be the cheapest and best there is in the

market. However, this means employees will be inclined to be less efficient if the standard

allows for a certain amount of inefficiency.

Calculating the Standard Cost

To calculate the standard cost of a single product, we must determine how much material

and labour the product requires and at what cost and rate; plus wastage.

Management Accounting 1 – Course Notes

Example:

A company sells tables and each requires:

• 2 metres of timber at $10 per metre

• 30 minutes for sorting, cutting and assembly labour at $20 per hour

Sorting usually finds that 1 out of 10 metres is usually defective and cannot be use

Thus, from our example, we can determine that the standard cost would be:

Direct Material: [2 + (0.1 x 2)] x 10

Direct Labour: 30 x 20

Standard Cost per Table:

Variances

After finding our standards and

setting them, we should regularly control

costs by comparing actual costs to standard

costs.

We can split variances in standard

costs to four different types of variances as

shown on the right.

In the following, negatives a

as favourable and positive values are seen as

unfavourable movements. While this may

seem incorrect, it is the correct interpretation

as actual prices are always put first.

Direct Material Variances

To calculate variances, we generally take the a

the standard from it. After this, we multiply

multiply by the other, which is quantity)

Price Variance

= Purchased Quantity (Actual Price

Quantity Variance

= Standard Price (Actual Quantity


Course Notes – Semester 1 2009

A company sells tables and each requires:

2 metres of timber at $10 per metre

30 minutes for sorting, cutting and assembly labour at $20 per hour

Sorting usually finds that 1 out of 10 metres is usually defective and cannot be use


[2 + (0.1 x 2)] x 10 = $22 (We take into account wastage here

= $60

= $82

After finding our standards and

setting them, we should regularly control

costs by comparing actual costs to standard

We can split variances in standard

ur different types of variances as

In the following, negatives are seen

as favourable and positive values are seen as

unfavourable movements. While this may

seem incorrect, it is the correct interpretation

as actual prices are always put first.

To calculate variances, we generally take the actual figure from that period and take away

the standard from it. After this, we multiply it by the other standard figure (say for price variance we

multiply by the other, which is quantity).

= Purchased Quantity (Actual Price – Standard Price)

= Standard Price (Actual Quantity – Standard Quantity)

Variances

DM Variances

Price Variance

Quantity Variance

Variances

WARNING!

Quality Control and Disposal

are always a

Overhead

part of the


22

Sorting usually finds that 1 out of 10 metres is usually defective and cannot be used.


(We take into account wastage here of 10%)

ctual figure from that period and take away

(say for price variance we

DL Variances

Rate Variance

Efficiency Variance

WARNING!

Quality Control and Disposal

are always a Manufacturing

Overhead and thus, is not

part of the Standard Cost!



Direct Labour Variances

The same strategy applies for direct labour as it does for direct material, only that we use

rate variance and efficiency variance instead.

Rate Variance

= Actual Hours (Actual Rate – Standard Rate)

Efficiency Variance

= Standard Rate (Actual Hours – Standard Hours)

Investigating Variances

After finding variances, management should not always investigate each and every variance.

This would be very time and cost consuming and only provide little benefit to the company.

Management should only investigate when:

• Variances are large (how large depends on the company)

• If it recurs (even if it is not a large variance)

• If there is a trend associated with it

• If it’s controllable

Both favourable and unfavourable variances need to be investigated. Much like every other

investigation we have seen in accounting, investigating variances also depends on the cost benefit

principle. If the cost of investigating it outweighs the benefits, then we should not do it.

Managers of each department can be held responsible for certain standards and thus, be

held accountable for variances. This helps establish cost control within the company and managers

do not like to be blamed for cost variances.

Costing and Tactical Decisions


CCoossttiinngg aanndd TTaaccttiiccaall DDeecciissiioonnss

Life Cycle Costing

Life cycling costing is an approach to costing whereby costs and revenue are managed over a

product’s entire life cycle (from initial design to when it is discontinued). This length differs slightly

from product to product.

A life cycle budget looks at the total accumulated profit or loss for the product over the

amount of years the product is designed to last for until it is discontinued. It also has to take into

account the time value of money, consumer tastes over the long run and competitors. As a result,

not many companies use life cycle costing as it is very hard to budget for over the long run.

Target Costing

Target costing is a system of profit planning and cost management which determines the life

cycle cost at which a product must be produced at to generate the desired level of profit.

To determine this, we first look at the market conditions. From this we can generate our

targeted selling price and our desired profit margin. Removing the margin from the targeted selling

price gives us the target cost which we need to aim for.

However, our current cost is usually higher than our target cost (if it isn’t why are we doing

this!). The gap between the allowable cost (The target selling price minus the target profit margin)

and the product-level target cost consists of the strategic cost reduction challenge which is

considered non-achievable. The target cost reduction objective (considered achievable) is the gap

between the product-level target cost and the current cost.

Our target cost reduction objective is realistic and can be achieved with component level

target costing, however, the remaining difference (the strategic cost reduction challenge) is usually

too hard to achieve practically in the short run and is thus, considered a challenge for the business.

Value engineering is usually used to minimise costs (this is where all non-value adding elements are

removed while still retaining customer value).

Target costing is good in that is works backwards, unlike other costing methods. It looks at

the market, what consumers want and is price led. This means that it is focused on the customer and

their expectations.

Tactical Decisions

Tactical decisions are those that do not require significant amounts of resources or

commitments and can be modified easily and quickly. As such, these are usually short-term. We use

the decision making process to help us decide what to do:

1. Clarify the problem.

2. Identify alternative courses of action.

3. Collect relevant costs and benefits.

4. Compare the costs and benefits of each alternative.



5. Select a course of action to undertake.

As usual, the information required to make a tactical decision must fit the cost-benefit

principle and the timeliness vs accuracy trade-off.

To Accept or Reject a Special Order

Special Orders are those which are one off orders from a new customer at a special price.

Usually, if the company has spare capacity to facilitate the special order, then the order should be

taken because it will generate profits, even if smaller than normal orders, for the business as it

utilises the otherwise idle capacity. However, we would not take the order if the special price is

lower than cost. This is just a case of costs vs. revenue.

Example:

You run an airline company and a tour group wanted to book out an entire plane on a route

for a special price. If you have an idle plane that’s not being serviced or is in revenue service, you’d

make profit by accepting that order, even if the price is a bit lower than usual. However, you must

still make sure that the revenue from that order will cover the costs of fuel, labour, fees etc.

However, this is a different story if there is no spare capacity available. We would have to

factor in the loss in revenue by not completing other orders. This is a cost contribution vs

contribution from the special order.

Example:

Continuing from the above, if you did not have an idle plane to fly, you would have a choice

of either cancelling a flight and using that plane to service this order or, to lease a plane temporarily.

Both of these would incur extra costs. Cancelling a flight would mean lost revenue on that flight and

leasing a plane would mean leasing costs would arise.

In such situations, we would need to see how much benefit the special order can bring. If it

brings in more revenue than the original flight, then it should continue. Otherwise, it should not be

accepted. This looks at the opportunity costs.

Example:

If a scheduled flight would have generated profits of $50,000 and the special order (using

that flight’s plane meaning we will not get that profit) will generate profits of $40,000, we would not

accept the special order as we would result in a net loss of $10,000 instead of a profit if we had kept

the original scheduled flight.

There are also other decisions to make other than just with cost. We have to ask ourselves:

• Is this really a one off order? Will they become a regular customer later?

• Will other customers find out about this special price and complain?

• Will this special order become a normal repeat order in the future? (Such as in the example,

if that special order flight became a regular flight)



We also need to take these into account when deciding whether to take a special order or not.

To Make or to Buy

Most companies have an option to make their own products or buy them. Continuing from

the example above, an airline company can choose to outsource catering it serves on flights instead

of using their own catering service. (For the purposes of this course, buying and outsourcing are both

the same thing).

Like the decision to accept or reject a special order, the decision to make or buy also

depends on capacity. When you decide to buy things that you make, you will suddenly have spare

capacity as you no longer need to make that product. Thus, you could use this spare capacity to

expand on other products or to make a brand new product. Opportunity costs need to be looked at.

Example:

If you outsource the making of drinks for an airline catering service, you will have excess

capacity left behind afterwards. This excess capacity can be used to expand food catering which will

bring in extra revenue.

We must note that by outsourcing, the company will save on direct material, direct labour

and some manufacturing overhead costs. However, costs such as depreciation are unavoidable.

There are also other issues with outsourcing:

• Is the quality of the outsourced product good?

• Is the timeliness of the supplier good?

• Is the supplier financially stable?

• Is the supplier stable overall?

To Add or Eliminate a Product or Department

Sometimes, removing a product or department from the business is required when it is not

seen as profitable to the business. Take our airline for example, the business class lounge may be

seen as unprofitable and management may want to discontinue it. However, discontinuing our

business class lounge will not just affect that department; it will also affect ticket sales for business

class seats.

Example:

If the airline were to remove first and business class from the airline’s fleet of aircraft, it

could potentially destroy its market of first and business class passengers. However, with the removal

of these seats, more economy class seats can be added which will result in higher economy

passengers. Also, since economy seats are smaller than their first and business class counterparts,

more people can be put onto one flight. This means that extra capacity is created across the entire

fleet. With the loss of first and business class also comes the closure of first and business class

lounges for extra savings. Businesses need to take into account how much the loss of first and

business class and the addition of more economy class seats will affect the bottom line.



With the addition of a product, the company needs to look not just at how it will affect the

bottom line, but also how it will affect other components in the business.

Example:

If the airline were to introduce a new flight on a new route, the business would need to:

• See if it needs to purchase/lease additional aircraft to service the new flight

• Increase maintenance, crew, catering, ticketing, admin costs due to more flights

However, if the airline did not need to purchase a new aircraft, then depreciation would not

need to be increased since it is already incurred.

Joint Products: To sell or to process further

Joint products are those that are produced simultaneously from one single process. Such an

example would be the production of petrol and LPG from oil refineries. Since these do not become

separate products until this process, accounting has a hard time assigning product costs and this is

usually done in an arbitrary method.

As a result, some companies may immediately sell the split product or, they may decide to

process it further for sale. Do we keep this as just normal car fuel or do we want to make aviation

fuel from it? This decision usually comes after analysing the costs associated with further processing

and the cost associated with the fact that we would have less of the original product to sell.

Costs incurred prior to the split-off point are irrelevant to the investigation and can be

regarded as sunk costs because they cannot be changed regardless of if we take on decision or the

other.

Tips for Tactical Decisions

• Always take into account opportunity costs.

• Always remember the qualitative decisions. It’s not just about the money.

• Take into account the effects on other departments/products/services.

Transfer Pricing


TTrraannssffeerr PPrriicciinngg

Decentralisation

Transfer pricing is a result of a move to decentralisation. Decentralisation is where the

business is restructured into smaller self sustaining business units. Such examples would be divisions

between different departments or divisions based on different geographical locations.

The benefits of decentralisation are that managers of each business unit will have a much

better understanding (and thus better decision making) of how things work as they do not have to

worry much about other business units. This allows higher level management to spend more time

on strategic issues instead of wasting time on low level issues. As a result, the business can react

faster to opportunities and problems.

However, each business unit has its own management team and acts as a business on its

own; meaning it can even compete with other business units in the same market. For example:

Liquorland and Vintage Cellars are both owned by Coles Group Limited, but both of them

compete in the same market for alcoholic drinks. Kmart and Target are also owned by Coles Group

Limited and they also compete against each other. This is an example of business units competing

against each other in the outside market; even though they are technically the same company.

With the above example, we find that there may be goal incongruence between the

business unit and the business as a whole. Goal incongruence is where the goals of the business

units are different from that of the company as a whole. Taking the above example, Kmart may be

unwilling to provide information to Target or compete too strongly against Target to the point where

it erodes the whole company’s profit. Kmart may be reaping in the profits but Target may be losing

more than Kmart is reaping in meaning the company as a whole, does not want this to happen.

Another problem is that services such as HR, IT, Finance and Accounting will be duplicated

among all the business centres and can lead to redundancy in the business as a whole.

Responsibility Centres

A responsibility centre is a sub-unit of an organisation for which a manager is held

accountable for. These come in the form of a:

• Cost centre

• Profit centre

• Revenue centre

• Investment centre (also known as Strategic Business Units)

The goals of these centres are for the things stated in their name. That is, the goal of a cost

centre is to minimise cost and for a profit centre, is to maximise profits. In reality, profit centres and

investment centres are used interchangeably.

Transfer Pricing


Shared Services

As noted above, decentralisation can mean that businesses will each have their own support

departments (such as HR, IT, Finance and Accounting). The solution to this is in the form of shared

services.

In turn, the service departments become a business unit in its own right. This business unit

will provide support services to the other business units in the company. However, business units

can choose to use an outside provider for these services which means that there is an incentive for

the shared services department to deliver high quality services at low prices.

As such, a shared services department is usually labelled as a profit centre so that the goal

of the centre is to look for value-adding products and not purely cost cutting (as would be in a cost

centre).

This gives the best of both worlds (centralised and decentralised).

Team-Based Structures

With decentralisation also comes team-based structures. These include flatter organisational

structures which allow ideas to flow quickly up and down the organisation when compared to a

conventional structure. Self-managed work teams are also formed within business units and have

much wider responsibilities than traditional teams.

As such, a team with large responsibility also brings employee satisfaction and thus,

improved customer satisfaction and increased productivity. These teams are often set as cost

centres to help lower costs in the business.

Financial Performance Reports

Because the firm is decentralised, the firm’s financial reports must also reflect this. Financial

performance reports are usually segmented into each of the firm’s units and shows financial results

which are appropriate for that unit.

This method means that even if the unit is managed very well by managers, but has poor

performance, the manager will not get penalised if he has no control over the factors that are

causing poor performance.

Some costs attributable to a business unit may have been incurred outside the unit and thus,

this cost needs to be allocated back to the unit. A common cost that is incurred outside is when

there is a cost that benefits not just one business unit.

Real-Time Reporting

Real-time reporting is possible with sophisticated computer technologies and allows

managers to access financial reports that are up-to-date with real time. This can give the firm a

competitive advantage if it can quickly analyse and interpret that information. The problem with this

is that it requires a virtual close. A virtual close is when the business’s accounting books are closed

virtually at any time. Many current systems can only close the books at the set periods.

Transfer Pricing


Another benefit of real-time reporting is that the business, as a whole, can generate

consolidated financial statements much faster than would be possible if it was not used. The

business would have to wait for each individual business unit to make its own financial statements

before it could be consolidated and published,

Transfer Pricing

Transfer pricing is the internal selling price of products/services between business units in a

decentralised organisation. This becomes revenue for the selling unit and a cost for the buying unit.

This allows each business unit to reflect their effort in producing a product by recording revenue.

Transfer prices should always support goal congruency and preserve and encourage independence

between the divisions.

Transfer prices are usually set by managers of profit and investment centres. However, top

level management may intervene and set a transfer price. They may also set a general policy for

transfer pricing. Such methods include:

• Market-Based Prices

This method bases the transfer price on external market prices and is strongly encouraged

when there is a large market for the product which is being transferred between divisions.

However, it does not always encourage goal congruent behaviour.

• Cost-Plus Prices

Most transferred items between divisions are incomplete and as such, there is no market for

the product outside the company. As such, this method finds the standard variable cost of

the unit and then adds a markup to it. Additionally, a product’s fixed overhead can also be

added in what is known as the standard absorption cost. However, this method can easily

lead to non-goal congruent behaviour as the cost is usually overpriced.

• Negotiated Prices

This is when the price is negotiated between the two divisions in question. However, there is

usually a conflict of interest and both managers may not be skilled at negotiating. The issue

of excess capacity can greatly influence the price.

General Transfer Price Formula

The general formula used for transfer pricing is:

Transfer Price = Additional outlay costs per unit incurred by supplying division

+

Opportunity cost per unit to the supplying division

Taxation and Transfer Pricing

Many companies intentionally set low transfer prices so that that the division in one country

records a loss, and such, does not have to pay tax. This allows companies to pay less tax if they move

all their profits to tax-havens through the use of transfer pricing.

Transfer Pricing


Service Level Agreements

A service level agreement is a contract between two business units to:

• Establish the service that will be provided from one unit to the other.

• Outline responsibilities of each party.

• Establish targets that must be met (such as price, quality and timing)

The agreement normally includes ways which the agreement can be changed or terminated

by either business unit. These agreements usually last for one or two years.

Managing Quality


MMaannaaggiinngg QQuuaalliittyy

First off, what is quality?

Quality is the “customer satisfaction that is associated with the experience of the product

or service”. This differs slightly to the ISO9001 definition which is the: “total features and

characteristics of a product or service that enable it to satisfy stated or implied needs”.

We must note that quality does not only apply to customers; it also applies internally.

Quality also matters when one employee passes work onto another employee. If the quality is bad,

then the employee will have to fix it up and thus, waste resources that would otherwise not be if the

first employee had higher quality standards.

Dimensions of Quality

Quality can be in many different forms including:

• Performance. How well does it function?

• Features. Does it have features people want?

• Reliability. The specific period of time where the product will have no faults.

• Conformance. Is it the same as the designed product?

• Durability. How long will it be until people will stop using the product?

• Serviceability. Can the product be easily repaired and maintained?

• Aesthetics. Does the product look pleasing to the eye?

• Perceived Quality. Does the product bring with it quality that people attribute to such a

product? Such as high price means high quality?

• Fitness for use. Is the product fit for the job it was designed to do?

While examining these, we must look for tradeoffs between these dimensions of quality.

Serviceability may be sacrificed for aesthetics and such.

Companies should always find what dimensions that the customers place most value on. It

should then improve quality on the dimension that customers place most value on followed in order

by those the customer ranks second, third and so on. This ensures that company will create a

product which the customers want. That is: we should match spending with importance placed on

quality dimensions by customers.

Views of Cost and Quality

Traditionally, people thought that high quality usually comes with a high price tag. However,

today, this is not the case as higher quality usually leads to higher efficiency, higher productivity

levels and lower wastage meaning lower costs. Up to 10% of defects were considered acceptable in

previous years and quantity was seen as better than quality as mass production started. These days,

the aim is to have 0% defect rate and without quality, quantity should not even need to be looked at.

While there is a short term trade-off between cost and quality, this is not the case in the

long term. We should always spend more on quality so that there are less defects and failures.

Managing Quality


Total Quality Management (TQM)

TQM is a corporate management philosophy whereby the business undertakes continuous

quality improvement. That is: there is no perfect quality and the business must continually strive to

reach a higher level of quality.

Cost of Quality (COQ)

The cost of quality report associates quality in dollar terms. Managers are more prone to act

when they hear that quality is costing the company a certain amount of money than if they hear that

quality is lowering customer satisfaction. It also helps to identify which quality problems are the

most problematic and costly for the business. Think back to variance analysis; it applies here too!

These can be split into two categories which can further be split into another two:

• Conformance Costs

- Prevention

These costs are incurred to prevent poor quality in the first place. Such examples include:

training and supplier evaluation.

- Appraisal

These identify poor quality (such as inspecting materials) after a certain activity is

performed (in this case, buying the materials). Another example is testing.

• Non-Conformance Costs

- Internal Failure

These are costs associated with products/services that fail to meet quality standards

after production, but before being sold to customers. Examples include: rework and

scrap.

- External Failure

These are the costs associated with products/services that have poor quality and are

delivered to the customer. Examples include: repairing products under warranty and

handing customer complaints.

The categorisation of these quality issues can help create awareness within the company

that poor quality is becoming an issue. It also allows managers to keep track of poor quality and how

much it is costing the company.

The Non-conformance to conformance ratio can be calculated from a report on this to see

how many quality issues are resolved before production begins. Generally, we would like this value

to be as close to zero as possible. Remember: prevention is always better than cure.

Direct Measures of Quality (DMOQ)

These are non-financial measures of quality in that they do not describe quality problems in

monetary terms. DMOQ can be put into two broad categories of:

• Internal

These are issues that the customer is not aware of and does not need to. However, it affects

the level of quality in the final product. Examples include: defect rates and downtime.

Managing Quality


• External

These are issues that the customer can see and has a stake in such as: response times, on-

time delivery, warranty claims and complaints.

DMOQ can also be represented by Statistical Process Control (SPC) and Pareto diagrams to

graphically represent quality issues and to allow prioritisation of issues.

Which is better?

So is COQ or DMOQ better? Both are good in their own ways. COQ can:

• Associate quality with money.

• Rank quality issues in monetary terms.

• Allows aggregation.

• Focuses on consequences and not the past.

DMOQ can:

• Identify root causes of quality problems.

• Be timely in that is can be determined faster than COQ.

• Facilitate direct solutions and feedback.

Variability Management

A part of quality is variability. Variability is a problem because it can adversely affect

customer perception. What would happen if you going a product which was had 100mL less than

advertised? You probably would not buy that brand ever again.

Variability also multiplies along the track at alarming rates. A bit of variability at the

beginning of the process can end up being a very large variation at the end. The worst situation is

when unfavourable variability stacks on every process towards the end. Imagine if this happened:

• We order 50 boxes and make 49 bottles worth of ingredient (usually 50).

• We then make 48 bottles of beverage from the 49 (we would be at 50 here usually as well).

We end up with 48 bottles instead of 50 here and this is only a two-step process! Imagine

what would happen in a real business with many processes. We could end up with a single bottle! As

such, variability is a big issue and it is usually monitored using statistical process control (SPC).

The importance of variability management is highlighted in the next chapter.

Conventional View

The conventional view to quality variability is that there is no loss when we are between the

upper and lower limits. However, loss applies the instant we move out of those boundaries. This

instantly assumes that out target cost is not accurate and is reminiscent of a practical standard.

Managing Quality


Quality Loss Function (QLF)

The quality loss function takes this one step further. Costs start to appear the moment that

quality moved away from its target. Instead of having to wait for the lower and upper limits to be

reached, cost is already being counted for. This takes away the assumption that out target cost is

inaccurate. As such, the quality loss function is a very good tool to use to quantify variability in a

cost of quality report.

The cost of quality under a quality loss function can be found through a formula:

L = k(Y-T)2

Where:

L = Unit Loss (also known as the Hidden Cost)

Y = Actual Value

T = Target Value

k = Proportionality Constant

k = c/d2

Where:

c = loss associated with unit produced at specification (lower/upper) limit

d = difference between target and specification limit

We need to note that this is a flawed formula that real companies do not use. However, we

use it in this course for the sake of being able to monetise quality.

The unit loss/hidden cost can also be put back into our COQ report under external failure.

The Theory of Constraints


TThhee TThheeoorryy ooff CCoonnssttrraaiinnttss

Prior to this section, we looked at cost management without regard to time. This chapter

looks at constraints and how to make the best use of time to get the best amount of customer value

and reduce costs.

Developing a New Product/Service

When we’re developing a new product or service, we can use two measures to assess the

timeliness of the product development process. We can use the time it takes to get from design to

the market or to the time it breaks-even in terms of money.

Usually, this time will be very long and we would want to minimise this time. Ways of doing

this include:

• Having suppliers know your business’s needs and wants so that they can work more

efficiently and thus, faster.

• Create a more efficient design process.

• Use team-based structures and decentralisation.

Time Taken to Fill Customer Orders

Another common time issue is the time it takes for a customer to place to order to when it is

delivered to them. The times are divided as such:

• Order Receipt Time: Time between order placement and when it is received.

• Production Cycle (Also known as Lead Time)

- Waiting Time: Time between order received and order setup.

- Production Time: Time between order setup and when it is produced.

• Delivery Time: Time between end of production and delivery.

Constraints

A constraint is something which stops you from doing more of what you want. For example,

you are driving along a road that has a limit of 60km/h but you are only driving at 40km/h because a

slow driver at the front. This slow driver is your constraint which is stopping you from going at

60km/h.

A constraint can be:

• External or Internal

This means the constraint is either inside or outside the business.

• Tangible and Intangible

This means that you can physically touch the constraint or not.

The best case scenario is where we have an internal tangible constraint such as a machine.

The worst case scenario is where we have an external intangible constraint as it can be very hard to

identify and/or remove.



Internal Constraints

Internal constraints are those that occur within the business itself. Such constraints include:

• Materials

Processes within the business do not have the required materials to do their work, possibly

because of something wrong with the process or previous processes or quality issues.

• Capacity

Machines may have different working speeds and this is a constraint.

• Logistical

These are planning and control issues and generally come in the form of variability.

• Managerial

These are strategies and policies implemented by management that may incidentally,

without management’s knowledge, constrain the business.

• Behavioural

Employees may have good days or bad days and such. Employees may work slower because

they don’t like something in the business etc.

External Constraints

External constraints are those that do not occur within the business. Examples include:

• Market constraints

There may be a limited market.

• Supply constraints

There may be government policies that restrict the level of supply of a certain product for

the market.

Binding Constraint

The binding constraint is the constraint which is the most harmful to the business. It is also

known as a bottleneck because all business processes before this point will cause a build up of work

before the binding constraint.

In our car example above, the person driving at 40km/h is the binding constraint because he

is making everyone behind him drive at 40km/h instead of 60km/h.


The global goal in business is to create more money now and forever. To do this, we have to

manage resources according to its ability to achieve that goal. This means focusing on constraints

before focusing on cost. To do this, we usually want to:

• Increase Throughput (T)

• Decrease Inventory (I)

• Decrease Operating Expenses (OpE)



Throughput is the rate at which revenue is generated from sales. It is simply the product

contribution margin for that item. That is: Selling Price – Variable Costs.

However! In this case, we only use direct materials as variable costs. Direct labour is not

considered a variable cost in this analysis but is instead, considered an operating expense. This is an

assumption we use in this course and only has a very short-term focus.

Inventory is not our usual inventory of things that we sell everyday during the course of the

business. It also includes property, plant, equipment, research and development and the direct

material component of “normal inventory”. This assumes that everything in the business is for sale.

Operating Expenses are costs other than direct material costs that are incurred to turn

inventory into throughput for the business.

Managing a Binding Constraint

The binding constraint is the one that causes the most harm to the business. As such, our

first step should be to identify this.

1) Indentify the Binding Constraint

This step means looking at the company’s processes and finding which one causes the most

harm to the business. This may not be clearly evident from the start. For example: we would

not clearly know that management policy to not work on Sundays could be the most harmful

one.

2) Exploit the Binding Constraint

This step is to keep the binding constraint operating at its maximum capacity so that other

processes can operate with less harm. To do this, we usually try to protect the binding

constraint from any variability and poor quality materials. Processing these would be a

waste of time, which is very important for the binding constraint. We should also continually

perform preventive maintenance so that the machine does not breakdown.

A good way is to build up a “buffer” of inventory before the process. If other processes

breakdown, they can catch up, but once the binding constraint breaks down, it can never

catch up because it is the slowest in the company.

3) Subordinate all other activities

This means that consideration of all other processes and resources should come after the

binding constraint. After all, the binding constraint is the most damaging to the firm. Other

processes should also generally work at the same rate as the binding constraint (drum beat)

so that inventory costs are decreased. If every machine is working faster than the binding

constraint, then the work will keep piling up behind the process (because it is the slowest)

and inventory costs will increase to keep that work there. It is also crucial for other

processes to communicate with the constraint to find out what’s happening (rope).

4) Elevate the Binding Constraint (if necessary)

This means taking measures to eliminate the binding constraint or to minimise its harm. This

can mean outsourcing work, investing in new machinery or redesigning the process or

product. Be careful with investing in new machinery because our goal is to decrease

inventory remember!



5) Rinse and Repeat the Process

Once you’ve fixed your binding constraint, it should no longer be one. Hence, something else

will now be the binding constraint! Rinse and repeat this process with the new constraint!

Limitations of the Theory of Constraints

The limitations of this are our assumptions:

• Only revenue and direct labour changes; everything else is fixed.

• The period of time in which our assumptions hold is very short.

• Reliance on finding a binding constraint. It can vary between periods and may not be

internal. External constraints usually cannot be controlled by the firm.

Variability, Responsibility Centres and the Theory of Constraints: The Big Problem

Variability (discussed in the last chapter as well) presents us with a huge problem when

applying the theory of constraints. Variability in the form of the speed of the process (sometimes it

takes longer to do something or shorter) means that sometimes, our binding constraint can move

around different processes. What this does it that it effectively throws all our plans out the window;

especially when it comes to dealing with the right product mix.

Take for example:

A company has 3 machines: A, B and C. Assume machine B has been identified as the binding

constraint and a product mix has been planned around it. If machine A always experiences variability

issues due to unreliable machinery, then the people at machine B (the binding constraint) may, at

times, have nothing to do (this is where an inventory buffer is important). However, in this situation,

variability can make machine A the binding constraint because it, suddenly, works less than machine

B due to variability issues. Workers at machine A may end up being overworked and workers at B

and C may find that they have a lack of control over what they can do and, as a result, motivational

issues arise (this is discussed in the Performance Evaluation and Control).

As you can see from this example, variability can present us with a bigger problem than first

expected. Thus, variability management is crucial to any business and thus, spending more on

conformance is a must.

This can further be exacerbated by responsibility centres (discussed on page 27). Say if the

sales department were a revenue centre, they would not care about costs and would continually try

to gain more sales which put even more pressure on the manufacturing department.

Resource Management

As a result of the Theory of Constraints one would want to look at what it can do in the short

and long terms. In the short term, it is generally best to exploit the binding constraint by optimising

it. In the long term however, this usually cannot be sustained and thus, the binding constraint

should be elevated.

Capital Expenditure Decisions


CCaappiittaall EExxppeennddiittuurree DDeecciissiioonnss

Capital Expenditure is expenditure that will generate long-term future cash flows.

Businesses decide whether or not to undertake these expenditures based on an evaluation of cash

inflows and outflows over the life of the project.

Businesses will undergo these expenditures for a variety of reasons such as:

• Achieving Strategic Goals

• Raising Profitability of the Business

• Government regulation purposes

• Infrastructure purposes

The Approval Process

All capital expenditure decisions require thorough analysis and approval before it can be

initiated. This is usually split into six steps:

1. Project Generation

This is coming up with the idea of the project in the first place.

2. Estimation and Analysis of projected cash flows

This is where cash flows are estimated based on data and managerial skills. Some project

initiators may include bias in estimating cash flows to make their project more attractive.

3. Progress to Approval

This is the authority required to approve the project. The larger the cost of the proposal, the

higher up the chain of authority the project has to go to get approved.

4. Analysis and selection of projects

Corporate management analyses and selects projects based on submissions.

5. Implementation of projects

Projects are implemented according to plan.

6. Post-completion audit of projects

The implemented projects are evaluated to compare actual results with estimated results.

Since this is a very long process, it is usually only full undertaken by large corporations. Small

businesses usually approve projects in a very informal manner.

The Incremental Cash Flows Method

This method considers all the incremental cash inflows and outflows in the situation that the

company has a choice of keeping the existing asset or to buy a new one.

Generally, Initial Costs and Inflows from the sale of the old asset do not apply if we are

keeping the original asset. We aren’t selling it off and the initial costs are already sunk costs. Apart

from this, differences can possibly occur in maintenance, revenue and other related things.

Take the following example:



Say if we had a choice of keeping Machine A that generates $1,000 of revenue using $200 of

materials and requires $500 of maintenance per year. We have a choice of buying Machine B for

$10,000 and it generates $2,000 of revenue using $400 of material per year and requires $400 of

maintenance per year. We can sell Machine A for $1,500 in the market today.

Cash Flow Keep Machine A Buy Machine B Increment if Buying Machine B

Initial Cost Not Relevant -$10,000 -$10,000

Sale of Machine A Not Relevant $1,500 $1500

Maintenance -$500 -$400 $100

Materials -$200 -$400 -$200

Revenue $1,000 $2,000 $1,000

In this example, we would also need to take into account the effect of the increment on tax.

Generally, a negative number means we will pay less tax while a positive number means that we will

pay more tax.

Calculating Tax

Following on from the above example, we found the amount of tax we pay changes based

on whether we get more expenses or more profit. For example, at a 40% tax rate:

If we our depreciation expense decreased by $10,000 our tax payments would increase by

$4,000 because we now have less expense and thus, more profits to pay tax on.

The Payback Method

The Payback Method is simple; it looks at how long it takes for cash inflows to break-even

the initial investment into the project. An easy example:

If the initial investment in the project is $9,000 (after-tax) and cash inflows per year are

$3,000 (after-tax), we would find that our expected payback is at the end of 3 years.

If cash flows are uneven, simply add them up in order and find when it breaks even.

The downside to the payback method is that it does not take into account the time value of

money and ignores all other cash flows after the payback period. However, it is a very simple tool to

use to roughly screen projects.

The Accounting Rate of Return Method

This method simply focuses on the accrual basis and not the cash basis. It is calculated with

by dividing the average annual after-tax profit from the project with the initial investment.

Once again, this method also does not take into account the time value of money and is

subject to all the accounting assumptions. However, it is good when used as a performance review.



Discounted Cash Flow Analysis

Discounted cash flow analysis looks at the time value of money. It considers the fact that

money can be invested in a risk-free bank account at a certain interest rate and such, something like

$100 could be worth $105 next year from interest. Two methods are the Net Present Value (NPV)

and Internal Rate of Return (IRR).

Net Present Value

Net Present Value simply takes the value of the cash flows from the project and discounts

them all to “year zero”, which is the date when the project begins.

Simply put, we divide the cash flow by (1+r)n where r is the interest rate (or the required

return rate) in decimals and n is the amount of years we want to discount by.

However, doing this for many cash flows would make it a very lengthy calculation. Hence, we

have tables that show us the present value of a dollar and the present value of an annuity of one

dollar. We can use these tables instead of calculating a huge equation to get our answer.

We only accept the project if the NPV is larger than zero. When considering other factors,

only consider quantitative factors and not qualitative factors as NPV analysis is quantitative.

Internal Rate of Return

The Internal Rate of Return is essentially the rate, that when put into the NPV equation gives

a NPV of zero. Since this is linked with NPV, the same rule applies where we only accept if the IRR is

larger than the required rate of return. If NPV is larger than zero, IRR will always be greater than the

required rate of return.

You generally will not be required to find the IRR as this is mostly trial and error until you get

the right figure; unless you are using a financial calculator which is not allowed in this course.

Comparison of NPV and IRR

Both NPV and IRR consider the time value of money and they both will provide the same

result when used on a project, effectively serving as a fail-safe in case of wrong calculations.

However, problems will arise when we assess multiple proposals.

Ranking Outcomes

Generally, when we evaluate proposals, we evaluate them based on the following:

• The NPV

• The IRR

• Timing of Cash Flows

• Life Span of the Project

However, we must note that the NPV is heavily biased towards projects with large cash

flows. Larger projects do not necessarily have a higher IRR.



This can be fixed by using the profitability index: Present Value / Initial Investment.

Overall, NPV is more advantageous in that it is much easier to calculate manually than IRR.

We can also adjust for risk by simply pushing the required rate of return up and the answer will

always be the same. We also reinvest based on the weighted average cost of capital, not the IRR

which is sometimes unrealistic.

The Limitations of a Conventional Analysis

Conventional analysis has many limitations such as:

• Its heavy reliance on estimating cash flows and hence uncertainty. This is especially

prevalent when using new technologies that no one has used before.

• Unrealistic status quo usage. This means that we are assuming the business can continue to

generate current cash flows if the project was not undertaken. Generally, if projects are not

taken, the business will lose competitiveness meaning a loss of cash flows.

• Required rates of return that are too high. Some businesses set these rates too high to

ensure that they suffer less risk. However, this can also work against the business in that not

many projects will ever succeed.

• Gaining approval for large projects is difficult. Since the larger the project is the higher up

management it must go, managers may decide to split a large project into smaller projects

so it does not have to move as far up the chain. However, the benefit of many smaller

projects is usually a lot less than one big project.

• Benefits that are hard to quantify are excluded. This means other aspects such as customer

satisfaction etc. are not accounted for. Sometimes, businesses may take a project that gives

a financial loss but a huge gain in benefits that are hard to quantify.

Dealing with these Limitations

To deal with these limitations we generally try to:

• Quantify any possible benefits as accurately as possible.

• Consider market and economic conditions and trends.

• Match the required rate of return to the level of uncertainty.

• Include strategic and competitive concerns.

• Conduct a sensitivity analysis so that managers can easily determine how a small change in

the project can affect its outcome.

• Conduct a multiple scenario analysis where different scenarios are analysed to see all

possible scenarios that could occur. This means finding the probability of something

happening and multiplying it by the NPV.

Post-Implementation Management

After implementing the project, management should review all projects and compare actual

to estimated cash flows. They have to find a way to record data without employees knowing as

employees will most definitely work harder when they know that they are being monitored.

Feedback should be provided so that future decisions can benefit from any lessons learnt.



Behavioural Implications

There is an implication that when performing evaluation, employees will work differently to

what they do normally as they know that they are being monitored and evaluated by management.

Managers may also reject projects that have a total positive NPV through their lifetimes but

have negative cash flows in the future. This is because it would look like the manager is not

performing well. Since profits will only arrive around 2 or more years after a project has begun, the

current manager may not be the manager anymore at that time. One way to avoid this is to avoid

using profit based performance measures.

The best way to solve this problem is to tell managers about the conflict between accrual

accounting and discounted cash flows. By using accrual accounting instead, managers may accept

the project as profits may be generated now, according to accrual accounting, but not according to

discounted cash flows. Accrual is what matters most as it appears on the financial statements.

Performance Evaluation and Control


PPeerrffoorrmmaannccee EEvvaalluuaattiioonn aanndd CCoonnttrrooll

The role of accounting information is to create and sustain shareholder and customer values.

To do this, it requires the performance of the individuals in the organisation as well as each

individual employee. To do this, you need to motivate employees to exert effort. This is where

control systems design comes in.

Control Systems Design

This is a system of organisational controls that are made to provide motivation for

employees to and to help them make correct and consistent decisions that are aligned with the

organisation’s objectives.

This means that the firm’s accounting systems must provide decision-facilitating (good

information) and decision-influencing (good information from the past) for control purposes.

Motivation

Motivation is defined as, “an individual’s intensity, direction and persistence of effort toward

attaining goals” (Langfield-Smith 2009).

Motivation comes in two forms:

• Intrinsic

This is motivation that comes from within the person. i.e. They want to do something just

because it interests them and they like it. For example, an artist would usually do it for

intrinsic value rather than for extrinsic.

• Extrinsic

This is the motivation that stems from the organisation such as cash bonuses, awards,

recognition etc.

From this, we can see that businesses can only control extrinsic motivation.

Factors affecting Motivation

Motivation is affected based on a large variety of factors including:

• Individual Characteristics

This is stuff such as the person’s interests, attitudes and needs.

• Job-Related Characteristics

This is the content of the job. Is it one that has a lot of variety? Is it difficult? etc.

• Work Situation Characteristics

This is the work environment such as work policies and business culture.

There are a variety of theories based on motivation and we will now look at three of them.



Goal Setting Theory

Goal Setting Theory is the belief that goals will improve performance via effort. It believes

that:

• Goals that are impossible will completely remove motivation.

• Goals that are too easy will reduce motivation to its minimum.

• Goals that are difficult but attainable will produce the most amount of motivation.

In addition, goals must be specific and workers should participate in goal setting as they will

end up being more likely to accept that goal since they had a say in it. Continual feedback should be

provided so that people know if they are performing in line with the set goals.

Goal Setting Theory is limited in that the goal has to be based on the person’s ability and

task complexity. If the person does not have the required skills to do a complex task, then the goal

will be impossible for that employee. Likewise, employees may not always accept the goal. It can

also promote tunnel vision in that employees will become too focused on their tasks and forget

about everything else.

Expectancy Theory

Expectancy Theory states that people are motivated in some way that provides an incentive

for them to act in ways which allow them to achieve that reward while preventing any penalties they

wish to avoid.

It shows the link between:

• Effort and Performance (Expectancy)

This shows the amount of effort the employee exerts that is reflected by performance.

• Performance and Outcomes (Instrumentality)

This basically asks, “Will I be rewarded for my performance?”

• Outcomes and Satisfaction (Valence)

Is this outcome something the employee wants? Is it satisfying their needs?

Expectancy Theory is limited when there is an internal binding constraint. An employee’s

expectancy is generally limited by the speed at which the binding constraint works at. Even if the

employee wanted to work faster, he/she cannot because the binding constraint would be working

too slowly; resulting in no work.

Agency Theory

Agency Theory is the differences in the interests of the principal and the agent. Generally,

the agent is motivated by self-interest and will not always work on behalf of the principal. This

means that the outcome is not necessarily the best one for the business as a whole. This means that

businesses need to either monitor their staff or create incentives that can overcome this problem.

In general, agents will want to use minimal effort to earn a particular reward. i.e. They will

try to manipulate the reward system to reap the maximum benefits.



Say if a lecturer’s performance is based on how many people pass the course, the lecturer

would purposely make the course very easy so that many people pass. However, this would

undermine university policy.

Agency Theory is generally considered to be the other side of Expectancy Theory.

Principles of Incentive System Design

There are seven principles to an incentive system design.

1. Use multiple measures of performance

Using only one measure promotes tunnel vision.

2. Employees must believe the reward results from something within their control.

If the reward is not within an employee’s control, then they will have no motivation.

3. Measure output vs. input

Output cannot always be reliably measured and is subject to uncontrollable factors. This

means we need to also look at input.

4. Link to the businesses critical success factors

Employees should be motivated to work on performance that is beneficial to the business’s

critical success factors.

5. Clear standards (SMART)

Specific, Measureable, Achievable, Realistic and Time Bound standards.

6. Accurate measures of performance

7. Group vs. Individual performance

Choices in Design

There are a lot of choices to make when designing an incentive system. We need to look at:

• Absolute or Relative performance

Do you measure performance based on previous data? Or do you measure it on a raw value?

• Formula-based or subjective measures

Do you use a formula? Or use subjective measures? We need to consider the fact here that

employees may try to find the formula and “cheat the system”.

• Financial or Non-Financial measures

Do you measure performance in dollar terms or other things?

• Range of responsibility

Is the range of responsibility for performance of an employee narrow or broad?

• Current or Deferred awards

Do you give the employee the reward now or do you give it over a staggered period of time.

Deferred awards make employees want to stay longer as they will get their bonus over a

long period of time for which they are entitled to.

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