Concept 1.1: Profit

Profit is a pivotal concept in business, and this is why it is the first one in this book. It

measures the economic value generated by an activity. It is defined as the difference

between revenues (the value of resources obtained from customers in exchange of products

and/or services) and costs (the value of resources used/consumed to generate revenues).

The profit equation can be expressed as follows:

Profit = Revenues – Costs

Or as:

Profit = Revenues – Expenses

Concept 1.2: Opportunity cost When facing a decision, the first thing to do is to identify the possible alternatives that can

be pursued. If the search process is not carefully done, people may let attractive

opportunities slip away. Identifying alternatives is not an easy task because most people and

organizations, especially those with a proven track record, are constantly confronted with

numerous decisions whose scope is often hard to define. From an economic point of view,

the various alternatives to a decision need to be compared to each other.

The opportunity cost is the economic value of the best, foregone alternative. The cash flow

of the second best alternative represents the opportunity cost of choosing the most

attractive option. Opportunity costs pop up all the time in real life but may not always be

valued in monetary terms. For example, a person may decide to stay at home to study,

rather than going out with a group of friends. The opportunity cost of studying is the

foregone enjoyment of spending time with friends. In this case, opportunity cost would have

to be valued in enjoyment rather than in money. However, when analyzing the economics of

a decision, only opportunity costs that can be measured financially are considered.

The steps to calculate the opportunity costs presented in Illustration 1.5 should remain with

you for the rest of your professional life.

‹ Concept 1.1: Profit

Concept 1.3: Cost behavior Managing costs represents a major challenge for all types of organizations. In the profit

equation, costs are often the main element under the control of management, while

revenues depend to a larger extent on market conditions.

Some costs happen no matter how many products are sold. For example, a car owner has to

pay insurance each month no matter how much he drives the car. The same is true with an

ice-cream factory that has a mortgage on its property. The company has to make the same

mortgage payments regardless of the factory's level of production. The costs that do not

change with an increase or decrease in the level of activity are called fixed costs.

On the other hand, variable costs fluctuate with the level of activity. While the insurance

payment is fixed each month, other payments such as gasoline change with driving amount.

The same situation happens with a business. When a factory increases production, it must

hire more workers and buy more raw materials, thus the cost of labor and materials

increases as production increases. In the case of the ice-cream factory, one variable cost is

milk because the more ice cream it produces the more milk it has to buy.

Illustration 1.6 presents graphs of a fixed cost and a variable cost. The x-axis is the volume

of activity (for example, the number of tanks of ice cream sold). The y-axis is total cost. The

first box shows the cost behavior of a resource whose total costs do not vary with the

number of tanks of ice cream, while the second box illustrates exactly the opposite. The first

box illustrates a fixed costs and the second illustrates a variable cost.

‹ Concept 1.2: Opportunity cost

Concept 1.4: Contribution margin The contribution margin is a key concept when making decisions. The first step in

calculating the contribution margin is to separate fixed from variable costs. The contribution

margin is the difference between revenues and variable costs. Companies report the

contribution margin in three different ways: (1) as an absolute amount of money for a

certain number of units, (2) as contribution margin per unit or (3) as a percentage of

revenues.

Total contribution margin = Revenues – Variable Costs

Or

Contribution margin per unit = Price per unit – Variable Costs per unit

Or

Contribution margin ratio (%) = (Revenues – Variable Costs) / Revenues

= (Price per unit – Variable Costs per unit) / Price per unit

Illustration 1.9 presents the steps to follow to calculate the different types of contribution.

‹ Concept 1.3: Cost behavior

Concept 1.5: Break-even analysis Break-even analysis is a widely used management tool. Managers use it constantly to

assess the attractiveness of various scenarios. For example, it helps them think about the

future when considering decisions such as launching a new product, modifying the sales

prices, changing the product mix, investing in a new production line, building a new plant, or

outsourcing the production of a specific item.

Break-even is the number of units that needs to be sold to have zero loss.

Therefore, breakeven analysis gives a sales target that needs to be exceeded to generate

profit. It is calculated as follows:

Break-even point (in # of units sold) = Fixed costs / Contribution margin per unit

Or

Break-even point (in € sold) = Fixed costs / contribution margin ratio (%)

The break-even point is also frequently identified using a break-even chart. The point of

intersection of the sales and costs lines is where sales are equal to costs. This point is called

the break-even point and losses are zero.

‹ Concept 1.4: Contribution margin

Concept 2.1: Indifference point The decision of whether or not to acquire the production equipment can be analyzed with a

concept called the indifference point, which has characteristics similar to those of the

break-even point (Concept #1.5). The break-even point can indicate the situation where a

person feels indifferently between two options because they both lead to zero profit. They

choose between doing nothing (thus having a profit of zero) and following the alternative

considered (where the profit at the break-even point is also zero).

The indifference point is based on being indifferent between two alternatives, but without the

constraint of having zero profit. Let us assume two alternatives: one is better if sales are

low, while the other is preferred when sales are high. Illustration 2.2 represents these two

options. The vertical axis is profit and the horizontal axis is sales volume. Alternative A is

better if sales volume is low; Alternative B is better if the sales volume is high. Notice that

there is a point where both alternatives give the same profit (point X). This is the

indifference point because at this sales volume, the economic prospects of both alternatives

are the same.

‹ Chapter 2: Creating Malea Fashion

Concept 2.2: Costs, assets and expenses Cost is the value of a resource. It can be the value of the time that a person works in a

company reflected in the salary paid to this person. It can also be the value of raw materials

or the value of production equipment like the one that MFD plans to acquire. Cost indicates

that a resource has a value. A gift may look like it has zero cost because nothing has been

paid for it — many people think this way, despite the flaw of this reasoning. While the gift is

free, it has an opportunity cost, usually very close to the price paid by the buyer.

There are two types of resources, thus two types of costs. There are resources that are fully

consumed in a period to generate revenues — called expenses. For example, the salary of

marketing, accounting and human resource managers are expenses. Once their time has

been consumed, it is gone. These costs are expenses because they reflect resources that

are fully consumed and, therefore, do not have future value.

There are also resources called assets that have not been fully consumed in a period to

generate revenues. For example, the equipment to produce ice-cram is an asset because it is

gradually used until the end of its life. A factory is another example of an asset because it is

used to produce in the current period, but it still has value for future periods. The costs of

these resources become assets of the company when they are acquired. Because assets are

used in future periods, they have value going into the future.

In short, whether costs are expenses or assets depends on if the resource is fully consumed

during a specific period or it still has value at the end of this period.

‹ Concept 2.1: Indifference point

Concept 2.3: Depreciation The concept of depreciation closes the cycle from costs to expenses. It reflects the value

that an asset has lost during a period through usage and/or passage of time. Over time

assets become expenses through depreciation. Most costs end up being expenses (some

of them immediately like those fully used in one period), though some are assets before they

become expenses. The distinction between an asset and an expense is usually simple — if

the underlying resource acquired has value at the end of a period, then the cost is an asset;

otherwise it is an expense.

The usual approach is to assume that the asset loses the same amount of value each year of

its life — this is called the straight-line depreciation method.

Illustration 2.8 presents the various steps to identify costs and expenses and to determine

the periodic decrease in value.

‹ Concept 2.2: Costs, assets and

Concept 2.4: Cost systems To estimate the full manufacturing cost of a product (the value of the resources which are

consumed to produce a unit of output), it is necessary to elaborate a model of how resources

are used. This model, called a cost system, traces, assigns or allocates — all these words

have the same meaning in the management world — the costs of the resources to the

products. The first component of a cost system is the variable cost of a unit. The second is

the fixed cost per unit, estimated by dividing manufacturing fixed cost by a measure of the

volume that can be produced. Adding variable and fixed costs per unit give the full cost of a

unit.

Illustration 2.9 presents the various steps to estimate the product cost of a unit.

‹ Concept 2.3: Depreciation

Concept 2.5: Death Spiral When tracing fixed costs to products, the volume used as denominator should be selected

with great care. Companies make the common mistake of choosing the actual volume as the

denominator. Often, they make this mistake because actual volume is the only denominator

allowed in financial reports for external parties. For managerial purposes, this mistake

exposes the company to a death spiral.

When using actual volume produced as the denominator, cost estimates will fluctuate with

this volume. If for some reason volume drops, fixed costs per unit increase correspondingly.

To maintain the same profitability level per unit the company may decide to increase the

selling price of its products. But higher selling prices lead to lower volumes. This vicious cycle

may cause the company to go out of business (see Illustration 2.11).

 

   

Concept 3.1: Product and period costs

Product costs are the costs of resources consumed in the manufacturing of products. They

include the costs of raw materials, and the costs of converting those materials into finished

products like the costs of labor and manufacturing equipment (through depreciation) and

facilities (called conversion costs). Distributors and merchandisers do not transform

products, so for them the only product costs are the purchasing price of the products they

sell. Service firms do not sell physical products, just services, so they have virtually no

product costs.

Period costs are the rest of costs — those unrelated to manufacturing like administration,

warehousing, marketing, advertising, and selling and distribution expenses. Financial

accounting rules in certain countries also consider research and development expenses as

period costs.

Concept 3.2: Income statement

The income statement is a fundamental document in any organization. It describes how

profits are generated over a certain period. This financial report is designed for inside and

outside use. Managers use it mainly to get information on the financial performance of the

organization as a whole during a certain period. Stakeholders such as suppliers, banks, and

employees use also the income statement to evaluate whether their investments or their

jobs are at risk and if they will generate the expected return.

Concept 3.3: Cash flow statement

The cash flow statement provides a picture on the sources and uses of cash during a

specific period. It is similar to a bank account statement, which lists deposits and

withdrawals. Usually divided into three sections, the cash flow statement distinguishes the

net cash flow resulting from operational, investment and financing activities.

cash generated by operating activities. There are two methods of computing operating

cash flows: the direct and the indirect method. The direct method simply lists the cash

inflow and outflow for that period, much like a bank statement. The indirect method takes

another approach and attempts to highlight why the net financial result (profit or loss) is

different from cash flow. It starts with the net profit and then adds back to it all non-cash

expenses (such as depreciation), non-cash revenues (such as credit sales), and changes in

working capital (such as increase in inventories, increase in accounts receivable, and

increase in accounts payable).

The next section of the cash flow statement describes cash flows related to investing

decisions. The investment and divestment of equipment for manufacturing and

merchandising companies often represent an important use of cash since these types of

organizations usually rely on sizeable fixed assets such as manufacturing plants or

warehouses for their operating activities. In certain cases, the acquisition of intangible assets

like patents and rights might require substantial amounts of cash.

The last section of the cash flow statement describes financing activities. It includes

transactions made with creditors and shareholders such as the reimbursement of loans,

issuance of new equity, repurchase of shares, or payment of dividends.

Concept 3.4: Balance sheet

The balance sheet keeps track of what the company owns and owes at a certain point in

time. On one side it lists the company's assets, and on the other it lists what the company

owes to its creditors (called liabilities). The difference between the assets of a company and

the liabilities is the net worth to owners (shareholders) called equity:

Equity = Assets – Liabilities

This equation can also be written the other way around:

Assets = Liabilities + Equity

The balance sheet statement is established according to reporting rules that vary between

countries but share many common characteristics.

Compared to the income statement and the cash flow statement that describe what happens

over a certain period of time (like a movie), the balance sheet is like a picture — it describes

what a company owns and owes at a particular point in time (see Illustration 3.9).

Concept 3.5: Return on investment and residual income

The income statement describes the profit generated by a company over a certain period of

time. However, to fully grasp the performance of the company, profits needs to be compared

to what was invested to get them.

It is obvious that a profit of €1,000 derived from an investment of €1,000 is a lot better than

the same profit generated from an investment of €100,000. Therefore, to evaluate financial

performance, investors consider a ratio called return on investment (ROI):

ROI = Profit / Investment

Managers focus on two main measures of return on investment (ROI). The first ratio called

return on assets (ROA) is profit before interest expense divided by total assets. It indicates

whether a company provides a good return on its assets. Profits are noted before interest

expense because this expense depends on how much debt the company has in the liability

side of its balance sheet. But it does not affect the asset side; removing interest expense

reflects this fact. Otherwise the ROA of two identical companies would differ simply because

one has more debt and the other more equity. The second ratio called return on equity

(ROE) evaluates the financial performance from the owners perspective. It is defined as net

profit divided by equity, and it indicates the profitability for the owners of the company. In

this case net profit is used because equity holders receive the net profit of the company

(after paying all expenses including interest and taxes).

   

Concept 4.1: Performance objects

A performance object is a specific aspect of the company that managers need to focus

their attention on to meet their business goals. Products and services are the classic

performance objects for which it is important to calculate the profitability. With this

information, managers identify the most profitable products so that they can promote those

and also identify the least profitable ones so that they can modify the business plan to

restore a healthy financial performance or, if not, eliminate them.

Concept 4.2: Direct and indirect costs

To determine the profitability of a performance object - this is, to compare the value of the

resources that it generates against the value of the resources consumed - revenues and

costs need be traced to that object. Direct costs are the cost of resources that a

performance object uses exclusively; these can be easily identified without ambiguity. For

example, materials and certain labor (direct labor) are often direct costs to products.

Indirect costs are the costs of the rest of resources — resources that various performance

objects share. For example, the cost of machines used to produce different products is a

shared resource. Resources that are not material or direct labor are called overhead costs.

Overhead costs are very often indirect costs.

Illustration 4.3 describes the steps to identify direct and indirect costs.

‹ Concept 4.1: Performance objects up Concept 4.3: Cost pools, allocation bases and

allocation rates ›

Illustration 4.3 describes the steps to identify direct and indirect costs.

Concept 4.3: Cost pools, allocation bases and allocation rates

The objective of cost systems is to accurately estimate the cost of performance objects, such

as products, customer segments, departments or processes. They have to reflect the

company’s economic model. Cost systems trace the costs of resources — raw materials,

people, rent, or machines — to performance objects. The idea is to estimate the cost of

resources consumed to deliver a product (or serve a customer), and then compare this cost

to the revenues that the product (or customer) generates to know whether it is profitable or

not.

The first step is to assign indirect costs to cost pools. A cost pool is a combination of various

indirect costs that have a similar cost behavior. Sometimes a cost pool is restricted to a

single resource when this resource behaves very differently from others (for example, one

particular machine). However, cost pools often include more than one indirect resource. An

important element to the accuracy of the cost system is how similar the cost behavior of the

resources in the cost pool is. Cost pools that include resources with very different behavior

will likely lead to cost distortions. There are no hard rules on how many cost pools to use. It

all depends on the cost system designer’s ability, and the desired accuracy of cost estimates.

Allocation bases trace the indirect costs accumulated in cost pools to performance objects.

Each cost pool has a unique allocation base. To get good cost estimates and prevent

distortions, allocation bases should reflect how performance objects impact the total cost of

resources in a cost pool. This is not always simple, and sometimes it is hard to find an

appropriate allocation base or difficult (or expensive) to measure it. Then, it is necessary to

select an allocation base that only approximates the real behavior of the cost pools.

Illustration 4.4 presents the steps to allocate indirect costs to products.

Illustration 4.4 presents the steps to allocate indirect costs to products.

‹ Concept 4.2: Direct and indirect costs up Concept 4.4: Job-order costing system ›

Concept 4.4: Job-order costing system

When each product is different, the cost system should be designed as a job-order costing

system. In some companies like a design studio, auditing firm, consulting company, or

custom furniture manufacturer, every job is different and it is therefore necessary to

estimate the cost of each separate product. This is in contrast to companies with few

products that are produced in large quantities according to the same specifications such as in

food processing or pharmaceuticals companies.

Concept 4.5: Process-costing system Process costing is used when all units produced are the same or the variation among

products is minimal. In contrast to job-order costing, units of the same product are not

treated separately. For example, each time MFD produces a fashion jacket the costing

system assigns it a cost that is the same as the cost of all other fashion jackets. In contrast,

each project in a consulting firm has a different cost.

Illustration 4.8 presents the main differences between job-order costing and process costing.

Concept 5.1: Price takers or price setters

When companies provide products or services that are standardized and hardly differentiated

from those supplied by competitors, they are forced to accept market prices determined by

supply and demand. Companies that do set prices above market prices are likely to face the

misfortunes of losing sales. Grains or metals (products that are the same regardless of the

producer) are examples of standard products, commonly referred to as commodities.

Individual suppliers and customers cannot change the prices of these products as they are

entirely subject to supply and demand — they are said to be in a price taking position.

In these markets, consumers have the upper hand and capture most of the value.

Conversely, companies that differentiate their products and services from those offered by

competitors have more freedom to set prices. Differentiation can occur when companies

offer unique product characteristics, combine products and services, market under a well-

known brand name, or distribute through a broad, professional network of dealers. Luxury

goods are the classic example of differentiated products, but the imagination has no limits

and business today is filled with examples of companies that successfully differentiate

themselves. For example, everybody consumes basic goods like sugar and water, but some

companies sell them under a brand name and charge a higher price. Through innovation,

these companies rise above the commodities market, avoid being price takers and become

price setters.

Concept 5.2: Cost based pricing

Cost-based pricing is a popular approach to setting prices. Companies that develop

products on demand or enjoy a price setting position often use it. Cost-based pricing sets

prices based on the full cost of a product plus a margin (or premium). The objective of this

premium above costs is twofold: to cover any costs that are not included in the full cost

(such as interest expenses) and to provide a return on investment to the shareholders of the

company. This approach to price setting has been deeply rooted in the habits of business

people for centuries for a very significant reason — the generation of a profit requires

companies to set price above costs.

Concept 5.3: Value-based pricing

Instead of looking at the market to set prices, cost-based pricing looks inwards. This

perspective has significant drawbacks and needs to be balanced out by alternative

approaches. Value-based pricing sets prices based on the customers’ perceived value

regardless of costs. The main idea of value-based pricing is to price products and services

profitably at what they are worth to the customer. Its purpose is not simply to satisfy

customers but aims at discovering their deep preferences and buying behavior. Value-based

pricing requires a thorough analysis of actual and future market trends.

Concept 5.4: Competition-based pricing

Competition-based pricing uses prices as a competitive weapon. Companies that follow

this approach usually pursue a growth strategy. To gain additional sales volume, they set

prices based not only on costs or value provided to targeted customers but also based on the

prices of their direct competitors. This approach questions the rationale behind looking for

higher volumes. Often companies believe that larger market share produces greater profit.

By lowering their price per unit, they expect to gain an additional sales volume that

positively compensates for the reduction of the contribution margin per unit (as a result of

their lower selling price). Sometimes they also hope that larger sales volume will lead to a

reduction of the unit cost due to a learning curve effect or economies of scale.

Concept 5.5: The 3C’s model for pricing

The 3C’s model was born out of the economic revolution of the 80’s when Japanese firms

entered the Western markets with quality products at a lower price. This flooding impacted

several aspects of the business world. First it reshuffled the cards in several industries where

Western companies were thought to be invincible. It also shed light on several managerial

innovations that were at the core of the Japanese model like Target costing, Kaizen costing,

and quality circles that forced Western companies to make a clear distinction between cost,

price and value. As a result, it led to the emergence of two sustainable, competitive

strategies: cost leadership and differentiation. Illustration 5.6 represents these two

strategies in a price-value market space and shows the game that could be played to

develop and maintain a competitive advantage.

The 3C’s model is a strategic framework that fundamentally emphasizes the importance of

understanding the internal and external business environment. It is based on three factors:

costs, customers and competitors. The model aims to encourage companies to bring more

value than their competitors at a lower cost to develop and maintain a competitive

advantage. It also highlights the trap of being “stuck in the middle” between companies

emphasizing cost and those emphasizing differentiation. This positioning of not pursuing a

clear strategy is often hard to sustain.

   

Concept 6.1: Relevant costs and relevant revenues Financially speaking, the relevant cash outflows and inflows are respectively called the

relevant costs and relevant revenues (or incremental and differential). These costs

and revenues meet two criteria. First, they happen in the future; past cash flows are

interesting as a basis of discussion but irrelevant since the past cannot be changed. Second,

they differ between alternatives; future costs or revenues that are identical to the

alternatives evaluated are not relevant for the decision process because they do not help to

distinguish the best alternatives from the rest. However, if irrelevant costs or revenues are

included in the analysis, they will not affect the final decision. Why? Because only the

difference between the cash flows of the various alternatives matters; adding or subtracting

the same number from all the alternatives does not change the difference between

alternatives. Illustration 6.2 presents the various steps to identify relevant costs and relevant

revenues to decide between different alternatives.

‹ Chapter 6: Cost Information for

   

Concept 6.2: Different costs for different purposes Cost is not just one number; it varies with its intended purpose. Costs are generally used for

four main purposes as shown on Illustration 6.3.

The first one is to decide. Every time managers face a decision, they should apply the

concept of relevant costs and revenues since they reflect expectations about the future cash

flows of different alternatives. Relevant costs and opportunity costs go together. The cash

flow of the second best alternative is an opportunity cost.

The second purpose of cost information is to evaluate the long-term profitability of

product and services. This requires the use of a cost system because it estimates the

value of the resources used to do something like performing a task, running a department,

manufacturing and distributing products, or serving a customer. With cost information,

managers are in a better position to make sure that the selling price of products and services

pay for the variable (usually the only short term relevant costs) and fixed costs.

The third purpose is to plan for the future and evaluate how events are unfolding. Once

the management team has decided on a course of action, periodic evaluations should be

conducted to assess the situation against the plan and change the course of action if needed.

In fast moving markets evaluation has also become crucial for encouraging learning.

The fourth purpose is to provide input to financial accounting. Companies have to value

inventories and cost of goods sold in their financial statements. This requires the estimation

of costs following financial accounting principles (rules). Actually, this purpose was very

important during most of the twentieth century, and decision-making and profitability

evaluation were basically ignored in managerial accounting training.

‹ Concept 6.1: Relevant costs and

Concept 6.3: Sunk costs and forward looking cash flows

So far we have learned about relevant costs and opportunity costs. Relevant costs are future

cash flows that differ between alternatives. Opportunity costs are the net cash flow of

alternatives that are not selected. An additional important aspect of using costs for decision

making is the concept of sunk costs.

When looking at the various alternatives to a decision, the only cash flows that matter are

future cash flows since they can be modified. Cash flows that happened in the past are

irrelevant. The reason is simple, the past cannot be changed; thus these cash flows are the

same regardless of the alternative selected.

Concept 6.4: All costs may be relevant

In a lot of operational decisions, relevant costs are all variable because fixed costs are fixed

across alternatives and therefore irrelevant. Because people face so many decisions where

fixed costs are irrelevant, they tend to think that the only relevant costs are variable costs.

They are not! Fixed costs can also be relevant. For example, buying special equipment to

execute a specific order includes a relevant fixed cost — the acquisition cost of the

equipment. This is an operating decision in which a fixed cost is a relevant cost. Opening a

sales office is another case where most of the relevant costs are fixed.

It is important to mention the concept of incremental costs, which is sometimes used to

compare two alternatives. Incremental costs are the difference between the relevant costs of

the two alternatives. For example, suppose you plan a vacation to the Alps and you are

trying to decide between two hotels, one of them costs €50 a night, while the other, a much

better hotel, costs €70. The relevant costs are respectively €50 and €70 a night and the

incremental cost of the second hotel is the difference: €20 a night.

Concept 6.5: Committed, discretionary, and engineered costs An important issue when facing decisions over costs is the distinction between committed

and discretionary costs. Some costs, like rent, are called committed. These costs are not

easily changed and are often fixed. For example, once a company has decided to rent a

place, the rent has to be paid regardless what happens. The cost of the rent remains as long

as the company stays in the same location. If the company wants to lower this cost, they

would have to relocate.

In contrast, discretionary costs are costs that can be adjusted relatively quickly. The costs

of marketing, training, exploration of new ideas are typically discretionary costs because

managers have the power to determine them. They are not variable costs because they do

not change with volume, so are often treated as fixed.

Another concept associated with committed and discretionary costs is that of engineered

costs. It is usually applied to variable costs and simply means that there are certain costs

that “automatically” accompany a certain decision. For example, if a table manufacturer

decides to sell an additional 100 tables, the material and labor costs will automatically

increase. If this manufacturer decides not to sell the additional tables, then these variable

costs do not apply. This is why they are relevant: they are engineered into the decision.

Illustration 6.7 presents an approach to identify committed, discretionary and engineered

costs.

‹ Concept 6.4: All costs may be relevant

   

Concept 7.1: Valuing inventories There are three types of inventories in manufacturing companies. The first one is the

inventory of raw materials that are used to manufacture the products of the company. On

the balance sheet, this inventory is categorized as an asset called “raw materials inventory.”

It is valued at the purchasing price of the raw materials, including out-of-pocket purchasing

costs.

The second type is called work in process (WIP) inventory. It includes all those products

that, at the date of the balance sheet, are inside the production process. Valuing this

inventory requires a bit more elaboration. First, manufacturing managers estimate how much

of each type of resources the products in process have utilized on average. The cost of raw

materials used is the percentage consumed times the raw material cost for the product. The

cost of direct labor and manufacturing overhead is estimated the same way.

The last type is finished goods inventory. These are the products that have already been

manufactured and are awaiting shipment to customers. They are valued at the full

manufacturing cost of the product.

Illustration 7.5 describes these inventories:

‹ Chapter 7: Recording Costs in Financial

Concept 7.2: Standard costs

Many companies use standard costs; they simplify everybody’s life. That way, managers

looking at the profitability of products or customers always see the same cost. Having the

same number avoids the distractions associated with minor fluctuations that are part of

reality but do not add to understanding what is going on at a company. Second, they simplify

the work of financial accounting people. If they used actual costs, they could not complete

the financial statements (the balance sheet and income statement) until they had recorded

all the costs for the period. With standard costs, they can record every transaction when it

happens. An additional advantage of doing so is that, at any point in time, financial

accountants can provide a good estimate of the company’s financial situation even if they do

not have all the actual costs. If standard costs are close to actual costs, the difference is

irrelevant for management decisions.

Concept 7.3: Cost allocation differences Financial accounting statements report actual costs. Thus, even if standard costs have

advantages, they need to be adjusted to reflect actual costs. For variable costs, the cost

allocation difference comes from discrepancies in the estimates used to build the standard

and actual costs. The actual costs come from what was spent to acquire resources.

Regarding fixed costs, cost allocation differences may come from two sources. The first is

the difference between the estimate of total fixed costs (used to determine the standards)

and the total actual fixed costs. The second comes from the difference between the expected

volume (used to estimate fixed costs per unit) and actual volume. Even if the total actual

costs are the same as the total estimated costs, a difference in volume will lead to a

difference between standard and actual fixed cost per unit.

Illustrations 7.9 describe the calculation and the treatment of variable cost allocation

differences.

Illustrations7.10 describe the calculation and the treatment of fixed cost allocation

differences.

‹ Concept 7.2: Standard costs

Concept 7.4: Conversion costs

Companies with process costing usually have various production stages. An apparel company

may have cutting, sewing, and packaging activities, while a chemical company may have

mixing, heating, cooling, and cutting stages. At each stage, resources are added to the work

in process and costs are recorded. Illustration 7.11 maps a typical process.

Costs that are added at each stage are called conversion costs.

‹ Concept 7.3: Cost allocation differences

Concept 7.5: Variable and full costing

Often financial accountants make the distinction between variable and full (or absorption)

costing. Variable costing only considers variable manufacturing costs as product costs,

while full costing includes all manufacturing costs (variable and fixed) as product costs.

Fixed costs in variable costing go directly to the income statement (they are period costs)

while they move through inventory before moving to the income statement as cost of goods

sold when full costing is used. In most countries, financial accounting rules only accept full

costing. However variable costing can be useful for comparison’s sake.

   

Concept 8.1: Financial plans Financial plans (also called budgets) express the future development of a company in

monetary terms. As presented in Illustration 8.2, they usually include a profit, an investment

and a cash plan. Financial plans are one of the most important management systems and are

widely used in companies of all sizes in all sectors.

Studies of business practices show that financial plans may play five distinct roles

(Illustration 8.3):

‹ Chapter 8: Planning for the Future

Concept 8.2: Profit planning — revenues The profit plan looks at future profits. It has the same structure as the income statement

but rather than summarizing the past, it projects the future. The objective of a profit plan is

to translate ideas for the future into financial numbers to see if they could deliver the

required value.

There are no hard rules about how to prepare a profit plan, but it is advisable to first develop

a revenue plan - the top line number in an income statement. To plan revenues, managers

have to agree on sales prices and volumes for their different products. Volume will depend

on variables such as the market size, market share and development of new markets.

Market size - markets for products and services experience a life cycle just as humans and

companies do. A market life cycle has different stages including development, growth, maturity,

and decline.

Market share - a more controllable source of growth is a company's ability to increase its share

of the market. Market share increases when a company does better than its competitors.

New markets - a third source of revenues is expansion into new markets. These markets can

be regions where the company does not already sell its products or markets for which an

innovative company develops new products.

Concept 8.3: Profit planning — expenses Once revenues are planned, the next step in the development of a profit plan is estimating

expenses. Those expenses related to manufacturing are particularly important because they

are based on assumptions about production volume, inventories, efficiency and the costs of

inputs.

Each type of expense presents different planning challenges :

Committed costs are easily estimated because they are known and rarely change in the short

term.

Engineered costsare based on other assumptions in the profit plan like volume, price of inputs

and productivity.

Discretionary costs are harder to plan; managers can set their level with few restrictions.

Illustration 8.13 summarizes the top-down financial planning that results in the expected

profit.

‹ Concept 8.2: Profit planning

 

Concept 8.4: Planning investments

To fully evaluate the economics of a strategy using financial plans, a planned profit should be

stated in relation to the investment needed to achieve it. Measures such as return on

investment and residual income are useful to this end.

Various investments may be required to execute a new strategy. For operations to grow,

companies may need to invest in fixed assets such as new machinery and in current assets

such as increases in inventories and accounts receivable. Each strategy should come with an

investment plan, detailing the increase in assets that the strategy requires. Growth is

usually contingent upon new investments so they should be carefully analyzed.

To evaluate the attractiveness of a financial plan using residual income, the cost of capital is

needed. The easiest solution is to use the existing cost of capital, assuming that the

company will be financed in the same way as it was in the past.

With all this information, the strategy can be estimated from an economic perspective as

follows:

Planned residual income = Planned Profit - (Planned Investment * Cost of capital)

Since investments bear their fruits over a long period of time, strategic decisions usually

affect much more than the company’s short-term economic situation. Therefore a thorough,

long-term analysis (usually several years) is imperative.

Concept 8.5: Planning cash flow — the cash cycle Before confirming the appropriateness of a strategy, a company must prepare a cash flow

plan.

A cash flow plan describes the planned movement of cash in and out of the company

during the year. A significant difference with the other two plans is that it is not enough to

develop a cash flow plan for the year (a list indicating the cash coming in and out of the

company for a 365-day period). Companies need to plan cash movements every month or, if

cash is short, every week or even day. Imagine a company that has all the cash payments

early in the year but does not collect cash until the end of the year. The yearly cash flow plan

may not show any signs of danger. But the company may run out of cash early in the year

and face a liquidity crisis with bills to pay and no cash in the bank. A badly managed liquidity

crisis — a consequence of a faulty cash flow plan — may mean the premature death of an

otherwise viable company.

An important reason for cash shortages is the length of the operating cash cycle. The cash

cycle describes how much time passes between the company’s scheduled cash outflow and

inflow. The cycle starts when the company buys materials from suppliers and finishes when it

receives cash from customers. The cash cycle becomes longer the more time the products

stay in inventory (because while they are in inventory, products can’t be translated into

cash) or the more time it takes customers to pay.

‹ Concept 8.4: Planning investments

 

Concept 9.1: Sales-adjusted profit plan

Periodically, at least once a year, it is important to analyze how the company performed

compared to expectations. The profit plan summarizes expectations, and the actual income

statement reflects actual performance. The difference between both is called performance

variance. Comparing profit plan and actual results (income statement) brings to light

information on how the company operates and sources of improvement.

The differences between the profit plan and the actual results are also called variances. They

explain how the company performed in the market (the sales side) and managed operations

(the expenses side). To examine them separately, a sales-adjusted profit plan is used. It

is the same as the original profit plan (static profit plan) but is built based on actual sales

rather than planned. Because it uses different sales statistics, planned costs also change with

respect to the static profit plan (sales volume affects variable costs) and result in a different

profit number. Thus, the profit number in the sales-adjusted profit plan reports what the

profit should have been given actual sales, assuming that operations worked as expected. In

other words, the difference between profits in the original profit plan and profits in the sales-

adjusted profit plan is due to the company's performance in the market.

Concept 9.2: Competitive variances Performance analysis starts by understanding the difference between the expected profits

from the original profit plan and actual profits (estimated using the sales-adjusted profit

plan):

Competitive variance = Profit from sales-adjusted profit plan – Profit from original

profit plan

Various factors may account for the difference including (but not exclusively):

Size of the market: the market was larger or smaller than planned.

Market share: the company captured a larger or smaller share than planned.

Product mix: the mix of products that the company sold was different from planned.

Product price: selling prices were different than planned.

Also, the company may not have information about certain factors (such as separating

volume and price to estimate the size of the market) and then the effect of these particular

factors on profit cannot be estimated.

If there is information on these factors, how do we estimate the impact on profit of each of

them? The process is simple, but must be done carefully. Starting at the original profit plan,

and one-by-one each variable that makes up sales must be changed from planned to actual

numbers. Each time one of these factors is adjusted, the profit plan is redone and the

change in profits reflects that factor's impact on profits.

Illustration 9.3 summarizes the step described above.

‹ Concept 9.1: Sales-adjusted profit plan

Concept 9.4: Operational variances — indirect costs The last piece of the performance analysis deals with indirect costs. Like for direct costs,

there are variances for variable and fixed costs. Variable indirect costs have two variances:

efficiency and spending, while fixed costs have only one: spending. The main difference

between direct and indirect costs comes in the efficiency variance. For indirect variable

costs, the efficiency variance is the difference between the profit plan with all actual results

except for indirect costs and a new profit plan that uses the actual amount of allocation

bases rather than the budgeted amount.

‹ Concept 9.3: Operational variances —

Concept 9.5 : Learning from variance analysis

Variance analysis raises questions that require answers. Investigating and discussing

these answers is an invaluable part of the process. Competitive variances raise questions

about the market. A larger market size raises the question of what forces are driving this

growth (i.e. Is it a new segment that the company may better serve?). A market share

variance points towards actions the company and its competitors took (i.e. Did competitors

come up with new products? Was the company late entering the market?). Price variances

are also useful. Sometimes prices rise thanks to market forces, in which case management is

just lucky. Alternatively, the marketing group may have improved the selling process that

was then reflected in better prices.

Operational variances can also point to interesting questions. Efficiency improvements can be

due to the learning curve. The learning curve simply says that there is learning in repeating

a process — be it is manufacturing, product development, marketing or any other business

process — but the rate of learning decreases as the number of units produced increases.

Concept 10.1: Cost distortions in traditional systems Traditional cost systems were designed in the early part of the 20th century to help

manufacturing companies evaluate the cost of goods sold and the value of the different

inventories. At that time, accuracy was not as big of an issue because business moved

slower and managers could rely on their intuition rather than cost information for decisions.

Also, the lack of information technology led to simple cost systems wherein product cost

estimates could be calculated manually.

At the beginning, traditional cost systems focused on manufacturing costs for two major

reasons. First, financial reporting rules only considered these costs as product costs for

inventory valuation. Second, manufacturing costs represented a very large percentage of

total costs and most of them were direct. As a result, a possible misallocation of indirect

costs could not have a large impact on product costs.

Over the past century, the world of business went through considerable changes making

traditional cost systems obsolete. In today’s companies, manufacturing is just one piece of

the puzzle; other costs such as R&D, marketing, distribution or administration have

increased substantially. So traditional costs systems give only a partial picture of the

situation. Moreover, indirect manufacturing costs are much larger and, if not properly

allocated, can bias product cost estimates.

‹ Chapter 10: Malea Fashion District

Concept 10.2: Activity-Based Costing Activity-Based Costing (ABC) is a different approach to design cost systems that takes into

account the complexity of today’s businesses. The mechanics are the same, but three

important design criteria distinguish ABC from traditional costing systems (see Illustration

10.3):

1. A system designed around organizational activities. The idea is that resources are used

in performing activities and a good cost system needs to understand how resources are used

regardless of which department uses them. Also, by looking at activities, ABC systems build

cost pools (called “activities” in ABC) that group resources with similar cost behavior together

because resources devoted to a particular activity behave similarly.

2. A system allocating costs based on causality. The ABC designer analyzes what drives the

demand for resources in a given activity and selects this driver to allocate costs to cost

objects.

3. A system that recognizes a larger variety of cost drivers. ABC systems recognize that

indirect costs vary over the long term, not only with business volume but also with other

factors that reflect the way the company is organized, the complexity of its operations,

products, customers, and distribution channels.

‹ Concept 10.1: Cost distortions in

Concept 10.3: Processes and Activities

Activity-based costing is grounded in the idea that managers do not manage costs, but

rather processes made of activities. To perform these activities, an organization consumes

resources like labor, equipment, energy, or space. By carefully analyzing the activities in

each process, managers can understand how resources are being utilized.

Every company is organized around processes, or groups of activities. Activities are often

classified into two categories: operational and support. Operational activities transform

inputs into outputs that customers value. These may involve the physical transformation of

materials into end products such as manufacturing, sales, or logistics or the development

and application of knowledge like product design. Examples include designing products,

purchasing inputs, manufacturing, marketing, selling and providing after-sales services. On

the other hand, support activities serve operational activities. Activities in human

resources departments like recruiting, training, or pension-related services are support

activities serving the people that work in operational activities.

Concept 10.4: Cost drivers

One of the main features of activity-based costing (not used in traditional costing) is the

assignment of costs to performance objects according to “cause and effect” relationships.

This requires the identification of costs drivers: variables that drive the consumption of

resources.

In ABC systems, cost drivers play the role that allocation bases did in traditional cost

systems and trace the costs from activities (the equivalent of cost pools) to performance

objects. However, the logic employed to choose cost drivers is very different from the one

used for allocation bases.

Cost drivers are the reason why the cost of performing an activity varies. A change in the

level of a cost driver prompts a change in the amount of resources spent to perform an

activity (the effect). For activities made up mainly of variable indirect costs, the cost drivers

are often clear; they cause the variation in the level of activity. For example, energy is often

a variable indirect cost that fluctuates with machine hours, its cost driver. Similarly,

transportation is often a variable indirect cost as it varies with the number of shipments. ABC

systems also recognize that there are more cost drivers than just volume (as traditional

systems often assume).

Concept 10.5: From Activity-Based Costing to Activity-Based

Management

In most cases, Activity-Based Costing increases the accuracy of cost estimates. For

companies where costs are an important variable, this is a critical piece in order to avoid

working with misleading data and making poor decisions. ABC not only provides better cost

estimates, it is also very helpful in managing activities, processes and the value chain.

ABC requires the identification of activities and the assigning of resources (and their costs) to

these activities. In doing so, managers learn about the cost of performing activities and can

compare this cost to its value to customers, determining whether it is worth it. While

identifying activities, managers often recognize activities with no or little value added. These

activities can safely be eliminated or redesigned to add value. ABC gives a clear picture of

the costs of operational and support activities that managers can use to achieve the most

efficient and effective organizational model.

   

Concept 11.1: Constraints and scarce resources

When companies grow, they may be unable to satisfy the demand that they face because

they do not have enough capacity; they face capacity constraints. This is particularly the

case of high growth companies whose capacity tends to lag the evolution of the volume of

demand. You can think of a capacity constraint as a narrow path that limits the flow of the

operations — this is why they are often called bottlenecks. For example, an assembly line

may work 24 hours a day and still be unable to process all the work required. A consulting

firm may not have enough consultants to serve the needs of its customers. An airplane may

not have enough seats to fly all its passengers. Or the kitchen of a restaurant may not be

able to prepare the meals fast enough to provide good service to its customers. In these

cases, the company is unable to acceptably meet its demand in terms of quality, speed, and

service because a resource is fully used, thus working at capacity. These are called scarce

resources because the company would like to have more of them, but it cannot mobilize

them in due time.

Concept 11.2: Contribution margin and scarce resources When facing a bottleneck that cannot be removed in the short run, companies need to decide

how to maximize the use of scarce resources. As always, the economic criterion is

which alternative yields more cash. In the presence of a scarce resource, this rule does not

change. However, looking at the contribution margin of products does not give the right

answer because different products (or customers or any other performance object) use the

resource differently. The issue is that there is a given capacity of the scarce resource (for

instance, a sales person’s hours of selling time). One product or customer may require twice

the amount of scarce resource than another one. Even if they have the same contribution

margin, the second will generate twice the cash. One approach to the decision is to look at

the cash generated under the various alternatives. But if there are many products and many

customers, the number of alternatives can become large. The other approach is to look at

how much cash the company gets per unit of scarce resource (see Illustration 11.5).

The product or customer that yields more cash is preferred first, then the second and so

forth.

‹ Concept 11.1: Constraints and scarce resources

Concept 11.3: Activity based costing and scarce resources Managing the economics of a company requires two different perspectives. One is the long-

term perspective. Costing systems (activity-based costing being the most advanced one)

give profitability information pertinent to this perspective. Profitability reports indicate how

much value each performance object generates over the long term. The other perspective is

short-term and indicates which course of action yields the most cash. This includes

examining relevant cash flows and contribution margin per scarce resource. Managers have

to work with both types of information, keeping an eye on the short term while planning for

the long term. It is important to note:

Product costing and cash flow analysis serve different, though equally important,

purposes

Profitability reports provide information about the long term and tell us which product or

customer is more profitable given the company’s cost structure. They reflect all the

resources that a product or a customer consumes. Cost estimates in profitability reports are

estimated using cost systems that rely on information from accounting system and thus

ignore opportunity costs. However, this is usually not a problem because opportunity costs

are similar to the costs recorded in the accounting system in the long run.

Relevant cash flow analysis focuses on a particular decision and its short-term effects on

cash. For pricing decisions, cash flow analysis typically equates to contribution margin

analysis. When there are bottlenecks, contribution margin per scarce resource becomes the

equivalent of cash flow analysis. For other operating decisions, relevant cash flows may

include not only contribution margin but also relevant fixed costs. This analysis must be

calculated for every decision, because each one is different. Also, though they are sometimes

left out of the accounting system, opportunity costs can also be important.

‹ Concept 11.2: Contribution margin

Concept 11.4: Outsourcing decisions The decision to perform an activity in-house or to rely on an outside supplier is often referred

as an “outsourcing decision” or “make or buy decision.” From an economic viewpoint,

they are not different from any other decision. Managers have to list the alternatives and

estimate the relevant cash flows to identify the alternative that leaves the company with

more cash. In outsourcing decisions there are typically two alternatives: (1) outsource or (2)

keep in-house, but there may be other alternatives like outsource some activities or bringing

some activities back to the company (referred to as insourcing). Interestingly, fixed costs are

likely to be relevant and opportunity costs not recorded in the accounting system play also a

significant role in estimating cash flows. Because these opportunity costs are not in the

information system of the company, they require a thorough specific analysis to be

identified. Illustration 11.7 presents the different steps of a ‘make or buy’ decision.

‹ Concept 11.3: Activity

Concept 11.5: Joint costs

Some products come out of the same processes and only become distinct products after they

split into different processes. For example, oil starts as one process — extraction — but by

the end of the manufacturing process, there are several products such as gas, gasoline,

kerosene, or asphalt. Pineapples start as one unit, but are split into rings, core (to do

pineapple juice) and skin. A TV program represents one process that can be delivered

through different channels. When estimating the cost of the final products, one often

considers what cost of the joint process goes to each product? For instance, how much of

the cost of the pineapple should go to the rings, core and skin? The processes that split into

several products are called joint processes and generate joint costs. Notice that they are

different from shared resources (indirect costs). Joint costs are incurred regardless of what

product is sought after. Indirect costs vary (in the short or long term) with the demand

imposed through cost drivers.

   

Concept 12.1: Time value of money Investment is a central concept in the world of business. Few businesses can generate large

returns without investing. This is why the term ‘investment’ is intrinsically linked with the

term ‘return’ — the soundness of an investment depends on its return.

To evaluate the economics of an investment, first list the alternatives and their relevant cash

flows over the life of the asset (usually several years). Cash outflows include the costs of the

new asset and of its operation. Cash inflows include operational savings and incremental

cash flows from the opportunities that the asset makes available to the company. An

important part of predicting cash flows is their timing because money today is worth more

than the same amount of money in the future. This concept is called ‘the time value of

money.

Why is this true? Because money today can be invested and earn interest. For instance, if

you invest €100 today at an interest rate of 5%, you will have €127.60 in five years: €27.60

more than €100.

Illustration 12.2 presents the steps to apply to identify and discount cash flows occurring at

different time periods.

‹ Chapter 12: Scaling Up — Investing

Concept 12.2: Cost of capital

The discount rate that is used to translate money across time — from the future back to

today or from today into the future — is an important number. The higher this rate is, the

less value future money has. The discount rate is often called the ‘cost of capital’ because it

represents the cost of using money.

The cost of capital depends on two main parameters. The first one is the economy-wide

interest rates. Central banks define a reference rate that is used to discount the safest

investments in the economy. This rate changes over time, and there are economic periods of

low interest rates and periods of higher rates.

The second parameter is the risk of the investment. Risk is the likelihood that the investment

will not pay the expected cash flows. For instance, a new product may not deliver the

expected cash flows because competition is tougher than expected, or customers are not

willing to pay as much as expected.

Concept 12.3: Net Present Value and Terminal Value The net present value (NPV) is the main financial criterion used to evaluate an investment

proposal. NPV employs the time value of money idea, but applies it to all the cash flows of an

investment decision and translates them into today’s money. Assume that an investment has

four cash flows: one today and one for each of the next three years. Today’s cash flow is

already in today’s money so it does not need to be translated. The cash flow a year from now

needs to be translated into today’s money so we divide it by (1 + cost of capital). Dividing by

(1 + cost of capital) considers the time value of money. The cash flow two years from now

also has to be translated, but because it happens two years from now, it needs to be divided

by (1 + cost of capital)2. Finally the cash flow in year three is divided by (1 + cost of

capital)3. We add the four cash flows (all in today’s money) to determine the financial value

of the project. The formula is:

Where ‘r’ is the cost of capital.

A positive net present value means that the investment creates value, whereas a negative

value means that the investment lowers it. From a financial standpoint, only investments

with positive net present value should be approved.

‹ Concept 12.2: Cost of capital

Concept 12.4: What if analysis ‘What if analysis’ is a tool to analyze the effect of changes in the assumptions of a plan. The

future is unpredictable and full of surprises. The best way to deal with this uncertainty is to

think about it and prepare an appropriate response.

‘What if analysis’ allows managers to see how the net present value varies with changing

scenarios. For instance, it can be used to examine how the NPV changes if marketing

expenses are increased to generate higher sales. It can also be used to analyze risk. For

example, the ‘what if analysis’ can visualize the effects of a 10% drop in sales in a certain

year, a faster-than-expected growth in sales, lower variable costs, larger fixed costs, or a

change in the investment level. An important outcome of this tool is an understanding of

what the critical assumptions of an investment project are. Large changes in some

assumptions have little effect on the final NPV, while small changes in others may have

drastic effects. These latter assumptions are critical to the investment, and managers should

devote special attention to these variables by carefully monitoring them and planning

responses.

‹ Concept 12.3: Net Present Value and

Concept 12.5: Performance evaluation and capital investments Cash flow and profits measure different aspects of management, and this difference can be

especially significant in investment decisions. Decision-making is based on cash flows, and

cash flows are the inputs to the Net Present Value concept. Because decision making only

considers the future, NPV projects all the relevant cash flows and discounts them at the cost

of capital to assess the economics of the investment. It measures the expected value that

the investment will generate.

Once an investment is made, it will generate cash flows and profits every year. If the

company is lucky and meets the NPV projections, then the yearly numbers will be as

projected. In most investments, there is a large initial cash outflow and then cash starts

coming in at an increasing rate until the project reaches its full potential. Looking at these

yearly cash flows, the early years often have very poor cash flows, while later years are

much better.

‹ Concept 12.4: What if analysis

   

Concept 13.1: Two stage allocation systems

As companies grow, support departments are created to aid operating departments. The

latter are directly involved in creating, manufacturing, and delivering products such as

incoming logistics, manufacturing, sales and marketing, storage and distribution, or after

sales. Support departments provide them with administrative services such as finance and

administration, public relations, legal advice, human resource management, or information

technology.

Because support departments serve operating departments, their costs cannot be traced

directly to performance objects — whether they are products, customers or any other

performance object. Moreover, their costs do not vary directly with the performance objects,

but with the type and intensity of support that the operating departments demand. To reflect

this economic reality, the costs of the support departments are not allocated to the

performance objects. Rather, they are allocated to the activities of operating departments

and through these are traced back to performance objects. This adds a new step to the

allocation process and is called a two-stage allocation system.

Concept 13.2: Allocation of support costs The allocation of support activities’ costs to operating activities is complicated by the fact

that support activities not only serve operations, but also each other. For example, the HR

department not only serves manufacturing and marketing, but also IT and finance; IT not

only serves operations but also HR and finance. To reflect the true economics of the

company, certain costs of support departments should be allocated to other support

departments. There are three ways to do so.

The simplest approach is called the direct method. It ignores the support departments’

service to each other and traces costs directly to the operating activities.

The second approach is called step-down, and it considers the fact that support costs serve

each other.

Finally, the reciprocal method is the most accurate, but also more complex and therefore

seldom used in companies. It takes the services that support activities give each other into

account.

‹ Concept 13.1: Two stage allocation

Concept 13.3: Single and double rates for allocating support

departments When allocating support departments, it is important to separate fixed and variable costs (as

it often is). Variable costs are relevant for short-term decision making, while fixed costs are

not. Also fixed costs are vulnerable to the death spiral while variable costs are not.

However, it is typical for companies to ascribe one rate that incorporates both fixed and

variable costs. This is called single rate approach and may lead to problems. For example, in

deciding whether to subcontract a support function such as HR, operating departments may

compare the single rate (that includes variable and fixed costs) to the external alternative

and decide to subcontract. This decision makes sense from the operating departments —

they get charged more internally than externally — but it may not be good for the company

as a whole. The outside option may be more costly than the variable costs in which case

subcontracting is more expensive overall because the HR‘s fixed costs cannot be eliminated

in the short term.

The dual rate approach leads to the estimation of two rates: one for variable costs and one

for fixed. So if the outside alternative is more expensive than the variable costs’ rate,

managers know that they should not subcontract. But if the outside alternative is cheaper

than the variable plus the fixed cost rates, then the operating departments know that the

support department is not as efficient as outside parties and needs to become more efficient.

If it does not, in the long term it may be wise to shut it down and move to an outside

supplier. Why? Because over a long enough period of time, both variable and fixed costs are

relevant and can be eliminated.

‹ Concept 13.2: Allocation of support costs

Concept 13.4: Target costing Managing costs starts at the product design stage, but managers often forget about it until

the product is manufactured or the service is offered to the public. As a rule of thumb, 80%

of the costs are determined at the design stage; so thinking about them early on pays off.

Target costing is a technique used to move cost management to the design stage.

Companies that do not manage costs at this stage take product costs after the design phase

and add a margin to them to determine a price at which it is profitable to sell. Hence price is

determined as follows:

Price = estimated product cost + margin

In this approach, product costs drive the desired price. But often it is the market that

determines prices, and there is little room to change it. So if the product ends up being too

costly, the profit margin may disappear. In contrast, target costing starts with the selling

price (from the marketing department) subtracts the margin that the company wants and

gets the targeted product cost:

Target price – target margin = target product cost

Frequently, product costs based on the first iterations of the product design are much higher

than those mandated by target costing. With target costing, product development teams are

aware from early on that their product is too expensive and work to reduce its costs.

‹ Concept 13.3: Single and double rates

Concept 13.5: Kaizen costing

Companies that gain their competitive edge through low costs do not stop at the design

stage. They continuously work to decrease costs throughout the item’s production using a

lifecycle cost perspective. Target costing is used early on, and then Kaizen costing

techniques are used once a product moves to the market.

The concept of Kaizen costing (meaning “constant improvements through small steps”) also

came from Japan. The basic idea is that devoting attention to cost reduction while a product

is on the market can lead to significant cost advantages. Though generally 80% of costs are

determined during the design phase, Kaizen costing addresses the remaining 20% and

gathers ideas for cost reduction of future products.

   

Concept 14.1: Customer profitability In the same way that a company can produce very different products, it can have very

different customers. Some can be easy to serve, while others may have unique

requirements, such as smaller lots, special designs, orders changes, delivery demands, etc.

Customers that demand more services cost more to serve. Providing excellent service is

often an important way to differentiate a company from its competitors, as customers’

perception of a product is not limited to the physical object; it includes the full experience,

where services play a critical role. But just as it is important to know the profitability of

products, it is important to know if customers with higher costs to serve are profitable.

Customer profitability is estimated using ABC concepts that you already know — identifying

activities, cost drivers, and cost driver rates.

The only difference is that the performance object is the customer or customer segments

rather than the product. This approach, looking at the customer rather than the product, is

most useful in understanding the behavior of marketing, sales, and post-sales costs.

However, it can also affect production activities (as in the case of customers demanding

unique features that require special setups).

‹ Chapter 14: Managing Customers and

Concept 14.2: Whale curve After estimating the profitability of each customer, it is informative to rank them from most

to least profitable and plot the accumulated profit in a graph — the x-axis has the ordered

list of customers; the y-axis has the accumulated profit. Therefore, the accumulated profit

for the most profitable customer is its profit, for the two most profitable customers is the

addition of their profits, and so on. This graph gives a good picture of how profitability

happens in a company.

This graph frequently proves that companies have very heterogeneous client portfolios.

Often, the distribution of revenues and profits fits the 80/20 rule, whereby the company

makes 80% of its revenues or profit from 20% of its customers. Typically it also reveals that

a profitable company is making money with one group of customers and losing money with

another large group of customers.

The shape of the graph resulting from this type of analysis often resembles the top of a

whale coming out of the water so the pattern is called the whale curve.

Accumulated profit increases with the most profitable customers usually above the overall

profit of the company until it reaches a maximum, and then profit decreases until the last

customer (at which point accumulated profit is equal to the company’s profits).

‹ Concept 14.1: Customer profitability

Concept 14.3: Life cycle profitability Customers, just as products and any other performance objects (for instance, new

geographical divisions), change their profitability over time. Early on, they are often

unprofitable, as companies need to invest to acquire new customers, develop new products

or establish their presence in new countries. These investments do not always pay off quickly

— and sometimes they never pay off (like when new products do not generate enough

demand).

Customers are said to go through various stages in their relationship with companies: birth,

growth, maturity, and exit. The birth stage is when the company invests to gain the

customer’s business. Then, if it has done a good job, the customer will use more of its

services thereby becoming more profitable until it reaches the mature stage, when the

customer has most of its business in that particular market with the company. The last stage

occurs when the customer decides to move its business to a competitor or stop carrying the

product.

‹ Concept 14.2: Whale curve

Concept 14.4: Design for X Most decisions about products and services are made during the design process. Target

costing focuses on managing costs, but it is only one dimension of a product. Then there are

other dimensions that, when considered during design, can make life easier (and often

cheaper) down the road, including when the product is released to the market. This is called

design for X. X can be various dimensions. For instance, ‘design for manufacturing’ uses

designs to simplify the manufacturing process. This can be as simple as color-coordinating so

that a piece that goes on the left is made in green and the right one in red, so that the

person putting the main product together does not waste time figuring out which one is

which.

Illustration 14.4 presents the ‘design for X’ concept.

‹ Concept 14.3: Life cycle profitability

Concept 14.5: Cost of quality Quality is an important aspect of any product that might succeed in the market place. Often

managers do not think about the cost associated with quality, but they are closely related.

This is where the cost of quality comes into the picture.

Cost of quality is divided into four types:

1. Prevention costs are the costs of producing quality the first time around and therefore

avoiding mistakes.

2. Appraisal costs are the costs of testing whether products and services have the promised

quality.

3. Internal failure costs are the costs of having to rework products and services flagged in

quality control procedures.

4. External failure costs are the costs incurred when the product or service fails in the

customers’ hands.

It is often said that, ‘quality is free’. The idea is that while it increases costs, investing in

prevention costs actually reduces the overall cost of quality because they lead to lower

internal and external failure costs. Such expenditures are wise and will be quickly recouped

via happy, returning customers who are willing to pay a bit more for quality, and who bring

new customers to the company.

   

Concept 15.1: Decentralization As companies grow, top managers cannot remain involved in every decision; instead they

have to decentralize (or delegate).

First, people have a physical limit on how much information they can absorb.

Second, moving specific information is expensive and slow.

Third, empowering employees strengthens their commitment to the company. Committed people

are a key ingredient in successful companies.

A final reason for decentralization is that the company does not depend on the abilities of a few

people. Rather it can take advantage of the abilities of all the employees of the company.

Decentralization is not as simple as shifting decision rights down the company. The new

decision makers need adequate information. So improved financial and non-financial

information is required, as well as access to it and appropriate motivation to understand how

their decisions help the company and their own careers.

Concept 15.2: Responsibility centers

Decision-making power is often decentralized from the top of the organization to the rest of

it. Managers responsible for the performance of divisions and departments are said to

manage responsibility centers. Several types of responsibility centers exist. In large multi-

divisional companies, divisions are often considered investment centers. Managers of

investment centers have decision-making power over most aspects of the business that

affect profit, including investment decisions. Their performance is often evaluated based on

RI (residual income) or ROI (return on investment) measures.

Managers of smaller divisions are often given decision-making power over areas that affect

profits, though investment decisions are kept at the top management level. These managers

are said to be in charge of profit centers because they have decision rights over profits (but

not investments). They make decisions that impact revenues and costs such as product mix,

distribution channel management, pricing policies, supplier selection, and hiring, promoting

and dismissing employees.

Concept 15.3: Goals, targets and rewards Setting up certain management tools makes decentralizing decision-making power successful

because managers are also responsible for implementing and executing their decisions.

Three tools are important to this end.

First, the manager who is granted new decision-making power has to know what decisions

he is responsible for and what he is supposed to achieve. Goals provide this direction. These

goals are then translated into much more specific objectives. Objectives are associated with

targets, the level of performance that the manager is expected to attain. Targets are

demanding to motivate managers to continuously improve.

The second tool is to move the necessary information to the decision makers. If a manager

is made responsible for quality, he needs to have timely, accurate, and relevant information

on quality.

The third tool is rewards. People like to be recognized when they have performed well and

achieved a target. This reward can be monetary, though recognition is what people tend to

value most. Complicating this is the fact that managers do not fully control whether a goal is

met.

It is therefore important to find the right balance between the scope of responsibility

assigned to the manager and his scope of control.

‹ Concept 15.2: Responsibility centers

Concept 15.4: Transfer pricing When one center sells to another center and both are responsible for their own profits, the

seller records a sale while the buyer records a cost — as if they were dealing with an outside

party. The issue that arises is at what price the transaction should happen. This internal price

is called transfer price.

The obvious solution to set transfer prices is to use market prices. Market prices lead to the

behavior that best serves the interest of the overall company.

When there are no comparable market prices, one alternative is to use negotiated transfer

prices, whereby the managers from the two responsibility centers negotiate a price together.

Another solution is to set transfer prices at variable cost. This is attractive because the

buying division sees the relevant cost and will therefore decide to accept any business that

brings positive cash flow to the company, consistent with the objectives of the overall

company.

The solution most often used in practice is to set transfer price at full cost (sometimes with a

margin). Full cost is attractive to the selling division because it gets paid for the resources

consumed. However, the buying division may reject businesses that are between the variable

and the full cost that might be attractive in the short term.

When market prices cannot be used to set transfer prices, there is no ideal solution.

‹ Concept 15.3: Goals, targets and

Concept 15.5: Balanced scorecard

Non-financial measures are important sources of information. But unless they are carefully

incorporated into a measurement system, they can be overwhelming. As companies grow

and become increasingly complex, there are hundreds of potential non-financial measures

(from sales and marketing to quality, process management, human resources or asset

performance). Without a guide to identify the relevant measures, they become obscured by

scores of less-relevant information. People tend to remember seven, plus/minus two, pieces

of information, so it is important to include only the most keep critical information to its most

important aspects.

One way to design a measurement system that reports the key pieces of information and

gives them a structure is the balanced scorecard. This tool is based on the strategy of the

company. Once the strategy is decided, it is then translated into a business model that

describes how the company creates value — from the resources required to its position in the

market, and financial performance.

The business model identifies the key aspects of the company’s strategy. Every point is then

associated with a measure.

Those measures identified in the balanced scorecard are then organized into perspectives.