COST MANAGEMENT BASICS

COST MANAGEMENT BASICS
COST PLANNING

Agenda Explanation of Cost & Cost Planning Computing Rates
Measuring Performance Master Data Identifying Requirements & Forecasting Benchmarking Establishing Operational Requirement Levels Setting Cost Targets The Role of Budgeting in Planning and Control Managerial Performance Reports

Explanation of Cost & Cost Planning

Cost Management Involves
Capture and Valuate Data Accurate, timely and relevant data Connecting operational output/performance data to financial data Allocate Overhead Cost Planning Controlling Analysis Accounting Management Process Cost Planning Set Cost Targets and Efficiency Goals Compute Standard Rates Cost Analysis Variances Depreciation Trends and forecasting Product, service or activity cost by element (labor, contract etc) Understanding full costs of organizations, operations, products and services Cost Controlling Move to action based on analysis Change targets Change resources Change quality

Amount of resources given up in exchange for some goods or services
What is cost? Amount of resources given up in exchange for some goods or services The amount of expenditure (actual or notional) incurred on, or attributable to, a specified thing or activity A foregoing, measured in monetary terms, incurred or potentially to be incurred to achieve a specific objective Discussion: What does cost mean to you? At home? Water, cable, phone bill To your organization? Maintenance, services, IT contracts

What is cost? Basic elements of cost: Raw materials Labor
Indirect expenses/overhead

Cost = Converting and Measurement of Work
Cost Center Asset / Equipment Project / Program Internal Order WBS / Work Order Organization - Labor, Materials, Supplies Resources/Inputs Plant, Property & Equipment Building Project, Weapon System Outputs Services, Events (SSP, Course) Job (Set of Tasks) – Maint & Repair 7

Cost Planning Cost Planning is the use of a Cost Model for “should-cost” forecasting to make informed decisions Often Performed for: Budget Requirements Requests Costs Estimations Output Quantities Capacity Management Risk Analysis Various Time Frames: Out year / Current year, Quarterly, Monthly Standard Rates Defining Targets to Measure Efficiency and Effectiveness Cost Accounting Cost Planning Cost Analysis Cost Management Process Planning – Both in terms of the $ but since we are talking about efficiency and effectiveness – Quantity as well Cost Controlling

What is Cost Planning? A cost plan determines the fiscal feasibility of an initiative. This is done by setting the lifecycle budgets and cost controls to manage the delivery and quality of the initiative's outcomes over a set timeframe. Cost Estimating and Cost Planning are not the same A cost estimate is an assessment or approximation of the likely costs of an initiative with an indication as to the degree of accuracy, usually +/- percent. In the construction industry—a good example of project management—a cost estimate is a prediction of the costs of construction.

Cost Planning Example In the construction industry, a cost plan is used as a way of controlling the estimated costs during the design and construction phases of a project. Cost plans are living artifacts, just like project management plans. They must be managed throughout the lifecycle of any initiative in any industry.

How to cost plan Art or science?
Sound commercial principles dictate how cost estimation migrates into cost planning right modeling tools experience

Guiding Principles Time is money
Risk and reward are opposites. The higher the risk, the greater potential for reward. If the risk is unsustainable, there'll be no reward. Appropriate controls to develop, implement and manage cost estimates and cost plans are the key to repeatable quality outcomes and commercial success. Cost estimating and cost planning outcomes provide the framework for cost control through the lifecycle of any initiative.

Cost Planning Highlights
Successful cost planning is made up of diversified choices in approach and execution. There is no one approach that fits all scenarios. Making the best and most appropriate choices to fit the situation. Before developing the cost plan for any initiative, you need to consider the framework. There are decisions that need to be made in order to determine the best approach for your cost plan and deliver the desired outcome and accuracy.

What is cost planning? Decisions to be made when determining the best approach: What is being planned? The principles are the same but the environment, approach and tolerances will be different. Is the opportunity a deal or a contract? A contract may have penalties for non-performance or delays. A deal is more of a partnership. Do I need to test the market with an RFI or RFP/RFT/RFQ? What is the commercial envelope? Is it a fixed lump sum, target sum, open book, or other? Has there been a sound assessment of the risk versus the complexity? What is the degree of confidence and/or accuracy? Do I need to obtain market coverage to sharpen the accuracy? Is there a comprehensive work breakdown structure (WBS) for services and materials? Do I have a strong understanding of the concept of money and the methods to determine the investment value or the return on investment? What about developing present and future value-of-money models? How does time affect the proposed cost plan? Is risk covered and are there adequate contingencies?

Cost Planning Summary The success formula for repeatable execution of quality cost estimates and cost plans is a combination of experience, commercial intellect, optimal choices of tools, and approach. Cost estimating and cost planning are both an art and a science. But most importantly, they require a strong dose of structure and discipline. And never underestimate what experience brings to the table.

Planning vs. Actual Data
Cost Planning aims to be predictive and to inform operational decisions. Cost Planning is necessarily speculative and approximate to some degree—variances in cost and other variables will always exist.

Starting Point: The Plan (Budget)
Just as in analyzing volume and performance variance we must start with an expectation This is the plan or budget The plan or budget must define two of the following three variables in the equation: cost = output x cost per output Some measure of output (like units) A measure of cost per output The total cost Furthermore, the plan defines these variables for all time periods or milestones within the project Activity Step 2: Explain the concept of schedule and cost variances in context of Earned Value Analysis Just as in analyzing volume and performance variance we must start with an expectation This is the plan or budget. Standardized EVM terminology uses the term “budget”. This simply refers to the plan, not to the formalized governmental budget. The plan or budget must defines two of the following three variables in the equation: cost = output x cost per output Some measure of output (like units) A measure of cost per output The total cost Furthermore the plan defines these variables for all time periods or milestones within the project. The budget or plan should answer the questions: How much work will be done? When will it be completed? How much will it cost?

Computing Rates

Computing Rates What is a rate?
Basic Definition: a quantity measured with respect to another measured quantity Miles per hour (mph) $ per gallon (gasoline, etc.) $ per kWh (kilowatt-hour; i.e. your electricity bill) Calories per serving Specific definition for our purpose: the cost per unit of a commodity or service $ per hour for electrician (i.e. DPW work at an installation) $ per hour for depot maintenance work (i.e. AMC)

Computing Rates Examples
Your water bill (i.e. cost per gallon of water) Primary considerations: Number of customers Forecasted total consumption; consumption per customer Equipment costs Labor costs Other considerations: Planned maintenance (replacing aging pipes) Unplanned maintenance (replacing damaged pipes) Rent/leasing a house ($/month) Mortgage costs (includes: principal, interest, insurance, taxes, etc.) Utilities Homeowners Association dues Maintenance costs Rental market comparables Profit Other considerations Unplanned maintenance (refrigerator dies) Unrented periods

Computing Rates Army rates discussion:
For most Army organizations, labor is the predominant resource used and is the key component for most services Therefore, the ability to accurately estimate and project labor costs is absolutely essential to help managers make informed operational and cost decisions Standard labor rates provide managers with a tool for developing estimates of current and future labor costs

Labor Rates Standard cost is any cost computed with the use of pre-established measures Standard costing is a costing method that attaches cost-to-cost objects based on reasonable estimates or cost studies and by means of budgeted rates rather than according to actual costs incurred A standard labor rate is the total value of costs planned for a workforce divided by the planned annual productive hours available for that workforce (planned labor dollars / planned productive hours). Stabilized labor rate is the standard labor rate established for a depot or other working capital fund activity and is a cost per direct labor hour (or other output measure) customers are charged for the products and services provided by a depot or activity group.

Labor Rate Example AMC charges standard rates for depot maintenance work, and ATEC uses standard rates when charging customers for test and evaluation support. It is imperative these rates include all the components of the full (AMC) or reimbursable (ATEC) cost incurred by these organizations when performing work for customers. Organizations should not only be able to identify direct costs, but also indirect costs when formulating rates. For example: ATEC includes overhead costs in the rates charged to non-DoD customers.

Establishing Standard Rates
Standard labor rates are based on documented labor and service (production) costs from previous fiscal years. These historic costs are adjusted for inflation, anticipated productivity changes and other factors that are expected to impact costs in the next fiscal year. The inclusion of leave within the Std. Rate is required to accurately associate the cost of work performed to the receiver cost object. Leave hours should be associated with the organization owning the resource, not charged to products/services, customers, or programs.

Establishing Standard Rates (cont.)
The organization must accomplish the following to establish the standard labor rates (next slide): Divide the organization into resource (cost) pools. For each resource pool, determine the total pay and benefits paid over the course of the fiscal year. For each resource pool, determine the total number of available work hours for the fiscal year. Note that this is not the number of hours for which employees were paid. It is the number of hours for which they were present for work. Leave is utilized within the determination of the productive work hrs available. Divide total pay and benefits by the number of available work hours to establish the actual historic labor rate. Adjust this historic rate by factoring in inflation, anticipated productivity changes, and other factors expected to impact labor costs in the next fiscal year. This is the standard labor rate for a resource pool.

GFEBS Standard Rates Example

Measuring Performance

Performance Measurement
Performance measures describe how well an individual has performed a task A good performance measure reveals the actions of the individual being evaluated Motivates individuals to act in the organization’s best interest and Cultural differences influence performance measurement

Performance Measurement
Certain aspects of financial accounting systems exist today because of the demand for performance measures Multiple performance measures generally will reveal an individual’s actions more accurately than a single measure

Example Performance Metrics
Quality and Performance Customer satisfaction measures Error rate Rework or scrap rate Internal failure costs Capacity Planning; Supplement C, Waiting Lines; Supplement H, Measuring Output Rates; Supplement I, Learning Curve Analysis Processing time Total time from start to finish (throughput time) Setup time Operating expenses Capacity utilization Average waiting time Average number of customers or jobs waiting in line

Example Performance Metrics
Constraint Management Cycle time Idle time Lean Systems Setup time Average waiting time Total time from start to finish (throughput time) Waste

Productivity Productivity = Units produced Input used Measure of process improvement Represents output relative to input Only through productivity increases can our standard of living improve

Productivity Calculations
Labor Productivity Productivity = Units produced Labor-hours used = = 4 units/labor-hour 1,000 250 One resource input  single-factor productivity

Multi-Factor Productivity
Output Labor + Material + Energy + Capital + Miscellaneous Productivity = Also known as total factor productivity Output and inputs are often expressed in dollars Multiple resource inputs  multi-factor productivity

Collins Title Productivity
Staff of 4 works 8 hrs/day 8 titles/day Payroll cost = $640/day Overhead = $400/day Old System: 14 titles/day Overhead = $800/day New System:

Collins Title Productivity
Staff of 4 works 8 hrs/day 8 titles/day Payroll cost = $640/day Overhead = $400/day Old System: 14 titles/day Overhead = $800/day New System: 8 titles/day $ = Old multifactor productivity = titles/dollar New multifactor productivity 14 titles/day $ = = titles/dollar

Measurement Problems Quality may change while the quantity of inputs and outputs remains constant External elements may cause an increase or decrease in productivity Precise units of measure may be lacking

Preferred Performance Measures
Preferred Performance Measures are those that are sensitive to or change significantly with the manager’s performance. They do not change much with changes in factors that are beyond the manager’s control They motivate the manager as well as limit the manger’s exposure to risk, reducing the cost of providing incentives May include Benchmarking

Performance Measures at the Individual Activity Level
Two issues when evaluating performance at the individual activity level: Designing performance measures for activities that require multiple tasks Designing performance measures for activities done in teams

Master Data

Master Data: Activity Types
An Activity Type represents a group of resources within a Cost Center. These resource groups have capacity and a unit of measure such as: labor hours, machine hours, square footage, etc. Activity Type Uses: Capture Capacity or Planned Output Example: technician works 2088 Hrs or machine runs 3500 Hrs (10 Hrs/Day for 350 days) Holds the rate for the output of the resource pool Example: $2 Hr, $5 Hr, $20 Hr Assigns capacity consumed by products/ services Example: Hrs/min worked per diagnostic test, which then valuates based on the rate

Master Data: Things You Do
Various other cost objects are used to represent the things that the Cost Centers/Orgs are providing: Internal Orders, Projects/Work Breakdown Structures, Maintenance Orders, etc. Internal Orders: are short term in nature, represent an event or job, do not replace the rigor of the Project/WBS Element structure Example: Courses, CLS-SSPs, Pre-Deployment, Professional Certification WBS Elements: sub-tasks within Projects used for planning, executing, and costing and managing dependencies Example: MEDCOM MRMC Labs projects, DPW Minor Constructions, Environmental clean-ups. Additionally, WBS Elements are used for reimbursable work either through a MIPR or as a Direct Charge. Business Process: Captures costs of cross-functional activities (the “work” performed by the Cost Center/Activity Types) and typically related to an action such as a “verb” Example: Pick Items, Pack Boxes, Ship Pallet

Master Data: Things You Track
A Statistical Key Figure (SKF) is a piece of information about the cost object it is assigned to Example: # FTE for a cost center, # of telephones, # of Students in a Class, # of Ads within a Campaign SKFs are used to: Capture non-financial information Calculate the basis (cost driver) for cost assignments Example: # of telephones to allocate out from the phone bill Measure performance Example: # of tests SKF can plan for the year and then actuals captured to report progress Calculate a unit cost rates

GFEBS Statistical Key Figure

Identifying Requirements & Forecasting

Quality Function Deployment
Identify what customer wants Identify how the good/service will satisfy the customer wants Relate customer wants to product how’s Identify relationships between the firm’s how’s Develop customer importance ratings Evaluate competing products Compare performance to desirable technical attributes

QFD House of Quality

?? What is Forecasting? Process of predicting a future event
Underlying basis of all business decisions Production Inventory Personnel facilities ??

Forecasting Forecasts are critical inputs to business plans, annual plans, and budgets Finance, human resources, marketing, operations, and supply chain managers need forecasts to plan output levels, purchase services and materials, workforce and output schedules, inventories, and long-term capacities Forecasts are made on many different variables Forecasts are important to managing both processes and managing supply chains

Average demand over 4 years
Components of Demand Trend component Demand for product or service | | | | Time (years) Seasonal peaks Actual demand line Average demand over 4 years Random variation

Trend Component Persistent, overall upward or downward pattern
Changes due to population, technology, age, culture, etc. Typically several years duration

NUMBER OF “SEASONS” IN PATTERN
Seasonal Component Regular pattern of up and down fluctuations Due to weather, customs, etc. Occurs within a single year PERIOD LENGTH “SEASON” LENGTH NUMBER OF “SEASONS” IN PATTERN Week Day 7 Month 4 – 4.5 28 – 31 Year Quarter 4 12 52

Cyclical Component Repeating up and down movements
Affected by business cycle, political, and economic factors Multiple years duration Often causal or associative relationships

Random Component Erratic, unsystematic, ‘residual’ fluctuations
Due to random variation or unforeseen events Short duration and non-repeating M T W T F

Naïve Approach Assumes demand in next period is the same as demand in the most recent period Example: if January sales were 68, then February sales will be 68 Naïve approach is sometimes cost effective and efficient Can be a good starting point

Demand Patterns A time series is the repeated observations of demand for a service or product in their order of occurrence There are five basic time series patterns: Horizontal Trend Seasonal Cyclical random

Moving Average Method MA is a series of arithmetic means
Used if little or no trend is present Used often for smoothing Provides overall impression of data over time

Weighted Moving Average
Used when some trend might be present Older data is usually less important Weights based on experience and intuition Weighted moving average

Exponential Smoothing
Form of weighted moving average Weights decline exponentially Most recent data = weighted most Requires smoothing constant () Ranges from 0 to 1 Subjectively chosen Involves little record keeping of past data

Trend Projections Fitting a trend line to historical data points to project into the medium to long-range Linear trends can be found using the least squares technique y = a + bx where y = computed value of the variable to be predicted (dependent variable) a = y-axis intercept b = slope of the regression line x = the independent variable

Least Squares Method ^ Time period Trend line, y = a + bx
Values of Dependent Variable (y-values) | | | | | | | Deviation1 (error) Deviation5 Deviation7 Deviation2 Deviation6 Deviation4 Deviation3 Actual observation (y-value) Least Squares Method minimizes the sum of squared errors (deviations Trend line, y = a + bx ^

Associative Forecasting
Used when changes in one or more independent variables can be used to predict the changes in the dependent variable Most common technique is linear regression analysis We apply this technique just as we did in the time-series example

Associative Forecasting
Forecasting an outcome based on predictor variables using the least squares technique y = a + bx where y = value of the dependent variable (in our example, sales) a = y-axis intercept b = slope of the regression line x = the independent variable

Correlation How strong is the linear relationship between the variables? Correlation does not necessarily imply causality! Coefficient of correlation, r, measures degree of association Values range from -1 to +1

Correlation Coefficient

Multiple Regression Analysis
If more than one independent variable is to be used in the model, linear regression can be extended to multiple regression to accommodate several independent variables Computationally, this is quite complex and generally done on the computer

Monitoring and Controlling Forecasts
Tracking Signal Measures how well the forecast is predicting actual values Ratio of cumulative forecast errors to mean absolute deviation (MAD) Good tracking signal has low values If forecasts are continually high or low, the forecast has a bias error

Tracking Signals Signal exceeding limit Tracking signal +
0 MADs – Upper control limit Lower control limit Time Signal exceeding limit Acceptable range

Adaptive Smoothing It’s possible to use the computer to continually monitor forecast error and adjust the values of the a and b coefficients used in exponential smoothing to continually minimize forecast error This technique is called adaptive smoothing

Focus Forecasting Developed at American Hardware Supply, and is based on two principles: Sophisticated forecasting models are not always better than simple ones There is no single technique that should be used for all products or services Uses historical data to test multiple forecasting models for individual items Forecasting model with the lowest error used to forecast the next demand

Seasonal Variations in Data
The multiplicative seasonal model can adjust trend data for seasonal variations in demand

Seasonal Variations in Data
Steps in the process for monthly seasons: Find average historical demand for each month Compute the average demand over all months Compute a seasonal index for each month Estimate next year’s total demand Divide this estimate of total demand by the number of months, then multiply it by the seasonal index for that month

Capacity and Scale Economies of scale Diseconomies of scale
Spreading fixed costs Reducing construction costs Cutting costs of purchased materials Finding process advantages Diseconomies of scale Complexity Loss of focus Inefficiencies

Average unit cost (dollars per patient)
Capacity and Scale Output rate (patients per week) Average unit cost (dollars per patient) 250-bed hospital 750-bed hospital 500-bed hospital Economies of scale Diseconomies of scale

Benchmarking

Benchmarking -Definition: Objectives:
A measurement of the quality of an organization's policies, products, programs, strategies, etc., and their comparison with standard measurements, or similar measurements of its peers. Objectives: to determine what and where improvements need to be made to analyze how other organizations achieve their high performance levels to use this information to improve performance

Types of Benchmarking Process benchmarking Financial benchmarking
Benchmarking from an investor perspective Benchmarking in the public sector Performance benchmarking Product benchmarking Strategic benchmarking Functional benchmarking Best-In-Class benchmarking Operational benchmarking Energy benchmarking

Typical Benchmarking Methodology
Identify problem areas Identify other industries that have similar processes Identify organizations that are leaders in these areas Survey companies for measures and practices Visit the "best practice" companies to identify leading edge practices Implement new and improved business practices

Marginal Costs Marginal Costs are the costs to produce one more additional unit of output The slope of the Total Cost Curve at any given level of production is the marginal cost for one more unit Marginal costs are highest at very low output rates and at output rates near capacity

Marginal Costs C B A Total cost Output Total (£) High marginal costs
Lowest marginal costs A High marginal costs Output

Average Cost is very high at low levels of output
Average Costs Average Cost is calculated by dividing the total cost by the total units produced Average Cost is very high at low levels of output

Approximations of Activity Costs
Activity costs are not always easy to estimate thus managers often use approximations One approximation is to use the market value of resources for the opportunity cost Total activity costs can be approximated using fixed and variable costs Fixed Costs Cost of using facilities, purchasing machines, hiring and training employees, and using other resources that do not change with the rate of output Variable Costs Cost of using additional labor, materials and other resources to increase the output of the activity

Earned Value Management
Earned Value Management (EVM) provides a common set of metrics for measuring both Schedule variance Cost Variance EVM combined with AAR offers a template for cost management and control of projects Activity step 1: Describe theory of Earned Value Analysis Earned value management (EVM) provides a common set of metrics for measuring both Schedule variance and Cost Variance. EVM is a recognized, standardized measurement of progress and cost used in project management. We are using the terms Earned Value Analysis and Earned Value Management synonymously. EVM combined with AAR offers a template for cost management and control of projects.

What Does Earned Value Mean?
Since there are risks to both cost and schedule, some method is needed to link the two Earned value measures what has been accomplished in terms of planned (budgeted) cost In this sense, it is similar to the flexible forecast we used previously in analyzing volume variance Just like in the flexible forecast, we will use the original planning factors to evaluate (in dollar terms) how much more or less work has been done Activity step 1: Describe theory of Earned Value Analysis Since there are risks to both cost and schedule some method is needed to link the two different dimensions Earned value measures what has been accomplished in terms of planned (budgeted) cost. In this sense it is similar to the flexible forecast we used previously in analyzing volume variance Just like in the flexible forecast we will use the original planning factors to evaluate (in dollar terms) how much more or less work has been done.

The Balanced Scorecard
Financial Perspective creating organizational value for owners/shareholders Customer perspective process adding value for customers Internal business process ensuring efficiency and quality in the value chain Strategy Learning and growth investing in organizational infrastructure

The Balanced Scoreboard
Each organizational objective has driver performance measures and outcome performance measures Driver Performance Measures: measure of input activities to achieve the objective Outcome Performance Measures: measures to determine whether the objective has been realized e.g. the number of employee training sessions is a driver performance measure for the objective of increasing employee skills to serve customers e.g. the number different services that an employee can offer a customer

Balance Scoreboard Example
Objectives Initiatives Performance measure Target Financial Perspective Increase shareholder wealth Develop new products Return on assets 25% Growth Increase online sales % growth in sales 30% Customer Perspective Increase market share Increased advertising % market share 10% Customer satisfaction Increase post-sales service % satisfied through survey 99% Internal business perspective Reduce throughput time Reduce non-value-added activities Average throughput time 4 hours On-time delivery Streamline delivery process % pm-time delivery 90% Reduce defects Quality teams % defects 0.01% Learning and growth perspective Multi-skilled workforce Employee training % of employees with multiple skills 80% Improve information systems Hire new employees in computing Number of employees in computing 20 Reduce employee turnover Pay higher salaries % annual turnover

Limitations of the Balanced Scoreboard
It is difficult to optimize performance across the 4 perspectives while making the appropriate trade-offs necessary to do so Over reliance on the financial perspective leads to an unbalanced scorecard which focuses on the short term The addition of too many measures leads to a unwieldy scorecard where managers are left to determine the relative importance of measures subjectively

Rewarding Performance Through Compensation Contracts
An organization can be viewed as a set of contracts that identify the assignment of responsibilities, the performance measures to evaluate the members, and how the benefits generated by the organization are shared Compensation is often used as a motivational tool

The Management Processes
Resource Managers Operational Managers $ Inputs Conversion “Work” Outputs Resources: Labor Material Equipment Supplies Contracts Assets Products Services: Courses Services Support Programs Tests Research Projects Training Events Work Performed by Organizations (Cost Centers) to Produce Products and Services for Customers 90 90 90

Setting Cost Targets

Estimating Product Costs for Planning Decisions
Planning decisions are improved with better estimates of product costs The costs and benefits of different decisions must be estimated The item to be costed is called the cost objective – the primary cost objects are the products or services provided by an organization The cost of using resources to provide a product or service is called the product or service cost

The Role of Budgeting in Planning and Control

Types of Budgets Master budget Operating budgets Financial budgets Time frame Annual period Multi-year rolling budget

Gathering information Forecasting sales Forecasting other variables The master budget starts with the sales forecast, which is the basis for the sales budget All other operating and most financial budgets are generated from the sales budget

Preparing the Operating Budget
The first budget is the sales budget which is based on the sales forecast Schedule 1 (in thousands) Starting point for ‘Production’ budget Starting point for ‘Marketing Expense’ budget Goes to ‘Budgeted Income Statement’

Schedule 2 (in thousands) Starting point for ‘Direct Materials Purchases’ budget Starting point for ‘Direct Labor’ budget

Schedule 3 (in thousands) * Follows the inventory policy of having 8 million pounds of materials on hand at the end of the first and second quarters and 5 million pounds on hand at the end of the third and fourth quarters. Goes to ‘Cost of Goods Sold’ budget

Schedule 4 (in thousands) Starting point for ‘Overhead’ budget Goes to ‘Cost of Goods Sold’ budget

Schedule 5 (in thousands) *Includes $200,000 of depreciation in each quarter. Goes to ‘Cost of Goods Sold’ budget

Schedule 6 (in thousands) aAmounts taken from Schedule 3. bAmounts taken from Schedule 4. cAmounts taken from Schedule 5. dBudgeted fixed overhead (Schedule 5)/Budgeted direct labor hours (Schedule 4) = $1,280/240 = $5.33. Goes to ‘Cost of Goods Sold’ budget

Schedule 7 (in thousands) *Production needs  $0.01 = 416,000  $0.01. Goes to ‘Budgeted Income Statement’

Schedule 8 (in thousands) Goes to ‘Budgeted Income Statement’

Schedule 11 (in thousands)

Operating Budgets for Various Organizations
Merchandising: Merchandise purchases replaces production Direct materials and direct labor are not required For-Profit-Service: Sales budget is the production budget Inventories are non-existent Not-For-Profit Service: Budget for the level and types of services produced Statement of sources and uses replaces income statement

Preparing the Financial Budget
Cash Budget Breakdown into short time periods Forecast need for short-term borrowing Forecast periods of high cash balances Beginning cash balance + Cash receipts Cash available – Cash disbursements – Minimum cash balance Excess or deficiency of cash – Repayments + Loans + Minimum cash balance Ending cash balance

Schedule 12 (in thousands)

Budgeted Balance Sheet Current (actual) balance sheet Integrate data from all other budgets

Schedule 13 (in thousands) a Ending balance from Schedule 12. b 30 percent of fourth-quarter credit sales (0.30 × $800,000); see Schedules 1 and 12. c From Schedule 3 (5,000,000 lbs. × $0.01). d From Schedule 6. e From the December 31, 2009, balance sheet. f December 31, 2009, balance ($9,000,000) plus new equipment acquisition of $600,000; see the 2009 ending balance sheet and Schedule 12. g From the December 31, 2009, balance sheet and Schedules 5, 8, and 10 ($4,500,000 + $800,000 + $20,000 + $40,000). h 20% of fourth-quarter purchases; see Schedules 3 and 12. i From the December 31, 2009, balance sheet. j $6,825,000 + $894,000 (December 31, 2009, balance plus net income from Schedule 11).

Shortcomings of the Traditional Master Budget Process
Department orientation: Plan from resources to outputs Does not recognize interdependencies among departments Static budgets: Developed for a single level of activity Based on incremental adjustments Results orientation: Disconnects the process from its output Cost-cutting accomplished by across-the-board cuts

Static Budgets for Planning and Control
Vital for planning Less useful for control Master budget developed around a single level of activity Budgeted activity level rarely equals actual activity

Static Budgets for Planning and Control

Flexible Budgets for Planning and Control
Variable budget Provides expected costs for a range of activity Provides budgeted costs for the actual activity level

Flexible Budget Performance Report: Compare budgeted costs given the actual level of activity to the actual costs for the same level Locate possible problem areas by examining the flexible budget variances Examines efficiency

Managerial Performance Reports

Have flexible budget variances Actual results vs. flexible budget Examines efficiency Has volume variances Static budget vs. flexible budget Examines effectiveness

Managerial Performance Report

A flexible budget can be built for five overhead activities using three drivers; each driver is budgeted for two activity levels

Activity Based Performance Report
Measures budget variances for each of the overhead activities

Activity Based Budgets
ABB begins with output and then determines the resources necessary to create that output ABB works backwards from activities and their drivers to the underlying costs Traditional budgeting relies on functional-based line items (salaries, supplies, etc.) Flexible budgets use cost behavior to split functional-based line items into fixed and variable

Traditional budgeting: relies on functional-based line items

Flexible Budgeting: uses cost behavior to split functional-based line items into fixed and variable costs

Steps to construct an ABB 1. determine the unit’s output 2. identify the activities (and related drivers) needed to deliver the output 3. estimate the demand for each activity 4. determine the cost of resources required to produce the relevant activities

The Behavioral Dimension of Budgeting
Characteristics of a good budgetary system Frequent feedback on performance Monetary and non-monetary incentives Participative budgeting Realistic standards Controllability of costs Multiple measures of performance

Planning Considerations

Planning Capacity Capacity is the maximum rate of output of a process or system Accounting, finance, marketing, operations, purchasing, and human resources all need capacity information to make decisions Capacity planning is done in the long-term and short-term Questions involve the amount of capacity cushion and expansion strategies

Measures of Capacity Utilization
Output measures of capacity Input measures of capacity Utilization Utilization = average output rate = % maximum capacity

Deming’s Fourteen Points
TABLE 6.2 Deming’s 14 Points for Implementing Quality Improvement 1. Create consistency of purpose 2. Lead to promote change 3. Build quality into the product; stop depending on inspections to catch problems 4. Build long-term relationships based on performance instead of awarding business on price 5. Continuously improve product, quality, and service 6. Start training 7. Emphasize leadership 8. Drive out fear 9. Break down barriers between departments 10. Stop haranguing workers 11. Support, help, and improve 12. Remove barriers to pride in work 13. Institute a vigorous program of education and self-improvement 14. Put everyone in the company to work on the transformation

Measuring Performance
Total Revenue: Increase sales through better customer service Cost of Goods Sold: Reduce costs of transportation and purchased materials Operating Expenses: Reduce fixed expenses by reducing overhead associated with supply chain operations Net Income: Improve profits with greater revenue and lower costs Return on Assets (ROA): Increase ROA with higher net income and fewer total assets Working Capital: Reduce working capital by reducing inventory investment, lead times, and backlogs Fixed Assets: Reduce the number of warehouses through improved supply chain design Net Cash Flows: Improve positive cash flows by reducing lead times and backlogs Inventory: Increase inventory turnover Total Assets: Achieve the same or better performance with fewer assets

Process Considerations
Push/pull method of work flow Quality at the source Jidoka Poka-yoke Anadon Uniform workstation loads Takt time Heijunka Mixed-model assembly Lot size of one

Two Ways Quality Improves Profitability
Improved response Flexible pricing Improved reputation Sales Gains via Improved Quality Increased Profits Increased productivity Lower rework and scrap costs Lower warranty costs Reduced Costs via

Resource Planning At the heart of any organization
Starts with sales and operation plans which helps when planning input requirements A process relative to the firm’s competitive priorities and an important part of managing supply chains

Enterprise Resource Planning (ERP)
An ERP system: Integrates a firm’s functional areas Is used by many different types of organizations How an ERP is designed: Single comprehensive database Mangers monitor all of the company’s products at all locations and at all times Information is automatically updated in the applications when transactions occur Streamlines data flows throughout the organization Requires a careful analysis of major processes Significant changes in ERP systems - interoperability

Conclusion

COST MANAGEMENT BASICS

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