cost management basics cost planning

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

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Explanation of Cost & Cost Planning

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Cost Management Involves

Cost Planning

Cost Controlling

Cost Analysis

Cost Accounting

Cost Management

Process

• Capture and Valuate Data– Accurate, timely and relevant data– Connecting operational output/performance

data to financial data– Allocate Overhead

• 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 Planning– Set Cost Targets and

Efficiency Goals– Compute Standard

Rates

• Cost Controlling– Move to action based on

analysis– Change targets– Change resources– Change quality

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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

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What is cost?

• Basic elements of cost:– Raw materials– Labor– Indirect expenses/overhead

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Cost = Converting and Measurement of Work

Cost Center

Asset / Equipment

Project / Program

Internal Order

WBS / Work Order

Organization - Labor, Materials, Supplies

Res

ourc

es/In

puts

Out

puts

Plant, Property & Equipment

Building Project, Weapon System

Services, Events (SSP, Course)

Job (Set of Tasks) – Maint & Repair

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Cost Planning

Cost Planning is the use of a Cost Model for “should-cost” forecasting to make informed decisions

Cost Planning

Cost Controlling

Cost Analysis

Cost Accounting

Cost Management

Process

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

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What is Cost Planning?

9

• 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

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– 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

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• 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.

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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.

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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?

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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.

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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

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Computing Rates

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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)

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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)– Primary considerations:

• 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

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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

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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.

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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.

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Establishing Standard Rates

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• 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.)

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• The organization must accomplish the following to establish the standard labor rates (next slide): 1. Divide the organization into resource (cost) pools. 2. For each resource pool, determine the total pay and benefits

paid over the course of the fiscal year.3. 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.

4. 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.

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GFEBS Standard Rates Example

Measuring Performance

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Performance Measurement

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Performance measures describe how well an individual has performed a task

A good performance measure reveals the

actions of the individual being evaluated and

Motivates individuals to act in the

organization’s best interest

Cultural differences influence performance measurement

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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

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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

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Constraint Management

Cycle time Idle time

Lean Systems

Setup time Average waiting time Total time from start to finish (throughput time) Waste

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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

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Productivity Calculations

Labor Productivity

Productivity =Units produced

Labor-hours used

= = 4 units/labor-hour1,000250

One resource input single-factor productivity

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Multi-Factor Productivity

OutputLabor + 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

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Collins Title Productivity

Staff of 4 works 8 hrs/day 8 titles/dayPayroll cost = $640/day Overhead = $400/day

Old System:

14 titles/day Overhead = $800/day

New System:

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Collins Title Productivity

Staff of 4 works 8 hrs/day 8 titles/dayPayroll cost = $640/day Overhead = $400/day

Old System:

14 titles/day Overhead = $800/day

New System:

=Old multifactor productivity

8 titles/day$640 + 400

= .0077 titles/dollar

New multifactor productivity

14 titles/day$640 + 800

= = .0097 titles/dollar

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Measurement Problems

1. Quality may change while the quantity of inputs and outputs remains constant

2. External elements may cause an increase or decrease in productivity

3. Precise units of measure may be lacking

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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

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Performance Measures at the Individual Activity Level

• Two issues when evaluating performance at the individual activity level:

1. Designing performance measures for activities that require multiple tasks

2. Designing performance measures for activities done in teams

Master Data

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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

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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

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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

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Identifying Requirements&

Forecasting

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Quality Function Deployment

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1. Identify what customer wants2. Identify how the good/service will satisfy the

customer wants3. Relate customer wants to product how’s4. Identify relationships between the firm’s how’s5. Develop customer importance ratings6. Evaluate competing products7. Compare performance to desirable technical

attributes

QFD House of Quality

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What is Forecasting?

• Process of predicting a future event• Underlying basis of all business decisions

– Production– Inventory– Personnel– facilities

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??

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

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Components of Demand

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Dem

and

for p

rodu

ct o

r ser

vice

| | | |1 2 3 4

Time (years)

Average demand over 4 years

Trend component

Actual demand line

Random variation

Seasonal peaks

Trend Component

• Persistent, overall upward or downward pattern• Changes due to population, technology, age,

culture, etc.• Typically several years duration

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Seasonal Component

• Regular pattern of up and down fluctuations• Due to weather, customs, etc.• Occurs within a single year

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PERIOD LENGTH “SEASON” LENGTH NUMBER OF “SEASONS” IN PATTERNWeek Day 7

Month Week 4 – 4.5

Month Day 28 – 31

Year Quarter 4

Year Month 12

Year Week 52

Cyclical Component

• Repeating up and down movements• Affected by business cycle, political, and

economic factors• Multiple years duration• Often causal or associative relationships

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0 5 10 15 20

Random Component

• Erratic, unsystematic, ‘residual’ fluctuations• Due to random variation or unforeseen events• Short duration and non-repeating

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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

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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

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Moving Average Method

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• 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

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• Used when some trend might be present – Older data is usually less important

• Weights based on experience and intuition

Weighted moving average

Exponential Smoothing

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• 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

60

• 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 interceptb = slope of the regression linex = the independent variable

Least Squares Method

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Deviation1

(error)

Deviation5

Deviation7

Deviation2

Deviation6

Deviation4

Deviation3

Actual observation (y-value)

Trend line, y = a + bx^

Time period

Valu

es o

f Dep

ende

nt V

aria

ble

(y-v

alue

s)

| | | | | | |

1 2 3 4 5 6 7

• Least Squares Method minimizes the sum of squared errors (deviations

Associative Forecasting

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• 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

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Forecasting an outcome based on predictor variables using the least squares technique

y = a + bxwhere y = value of the dependent variable (in our example, sales)a = y-axis interceptb = slope of the regression linex = the independent variable

Correlation

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• 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

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Multiple Regression Analysis

66

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

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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

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Tracking signal

+

0 MADs

–

Upper control limit

Lower control limit

Time

Signal exceeding limit

Acceptable range

Adaptive Smoothing

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• 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

70

• Developed at American Hardware Supply, and is based on two principles:

1. Sophisticated forecasting models are not always better than simple ones

2. 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

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

Seasonal Variations in Data

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Steps in the process for monthly seasons:

1. Find average historical demand for each month2. Compute the average demand over all months3. Compute a seasonal index for each month4. Estimate next year’s total demand5. Divide this estimate of total demand by the

number of months, then multiply it by the seasonal index for that month

Capacity and Scale

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• Economies of scale– Spreading fixed costs– Reducing construction costs– Cutting costs of purchased materials– Finding process advantages

• Diseconomies of scale• Complexity• Loss of focus• Inefficiencies

Capacity and Scale

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250-bed hospital 500-bed

hospital

750-bed hospital

Output rate (patients per week)

Ave

rage

uni

t cos

t (d

olla

rs p

er p

atie

nt)

Economies of scale

Diseconomies of scale

Benchmarking

75

Benchmarking

-Definition:• 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:(1) to determine what and where improvements need to be

made(2) to analyze how other organizations achieve their high

performance levels(3) to use this information to improve performance

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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

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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

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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

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Marginal Costs

Output

Total (£)

Total cost

High marginal costs

A

CHigh marginal costs

BLowest marginal costs

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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

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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 CostsCost of using facilities, purchasing

machines, hiring and training employees, and using other

resources that do not change with the rate of output

Variable CostsCost 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

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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

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The Balanced Scorecard

Financial Perspectivecreating organizational value

for owners/shareholders

Customer perspective

processadding value for customers

Strategy

Learning and growthinvesting in organizational

infrastructure

Internal business process

ensuring efficiency andquality in the value chain

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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

e.g. the number of employee training sessions is a driver performance

measure for the objective of increasing employee skills to serve customers

Outcome Performance Measures:

measures to determine whether the objective has been realized

e.g. the number different services that an employee

can offer a customer

87

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 10%

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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

The addition of too many measures leads to a unwieldy scorecard where managers

are left to determine the relative importance of measures subjectively

Over reliance on the financial perspective

leads to an unbalanced scorecard which

focuses on the short term

89

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

Inputs Conversion“Work”

Outputs

Resource Managers

Operational Managers

$

90

Resources:LaborMaterialEquipmentSuppliesContractsAssets

Products Services:CoursesServices Support ProgramsTests Research ProjectsTraining Events

Work Performed by Organizations (Cost Centers) to Produce Products and Services for Customers

90

Setting Cost Targets

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92

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 Planningand Control

93

The Role of Budgeting in Planning and Control

94


• Types of Budgets– Master budget

• Operating budgets• Financial budgets

• Time frame– Annual period– Multi-year rolling budget

95


• 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

96


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Preparing the Operating Budget

• The first budget is the sales budget which is based on the sales forecast

Schedule 1 (in thousands)

98

Starting point for ‘Production’ budgetStarting point for ‘Marketing Expense’ budget

Goes to ‘Budgeted Income Statement’



99

Starting point for ‘Direct Materials Purchases’ budgetStarting point for ‘Direct Labor’ budget



100

* 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



101

Starting point for ‘Overhead’ budget




102

*Includes $200,000 of depreciation in each quarter.




103

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.




104

*Production needs $0.01 = 416,000 $0.01.




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106




107




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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

109

Preparing the Financial Budget

• Cash Budget– Breakdown into short time periods– Forecast need for short-term borrowing– Forecast periods of high cash balances

110

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



111



112



113


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

114



115

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

116

Static Budgets for Planning and Control

• Static Budget:– Vital for planning– Less useful for control– Master budget– developed around a single level of activity– Budgeted activity level rarely equals actual activity

117

Static Budgets for Planning and Control

118

Flexible Budgets for Planning and Control

• Flexible Budgets:– Variable budget– Provides expected costs for a range of activity– Provides budgeted costs for the actual activity level

119


120


• 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

121

Managerial Performance Reports

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• Have flexible budget variances– Actual results vs. flexible budget– Examines efficiency

• Has volume variances– Static budget vs. flexible budget– Examines effectiveness

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Actual results

Flexible budget

Units produced 3,000 3,000 - Production costs:

Direct materials 927.3$ 780.0$ 147.3$ UDirect labor 360.0 360.0 - USupplies 80.0 90.0 (10.0) FIndirect labor 220.0 210.0 10.0 UPower 40.0 60.0 (20.0) FSupervision 90.0 100.0 (10.0) FDepreciation 200.0 200.0 - Rent 30.0 20.0 10.0 U

Total Costs 1,947.3$ 1,820.0$ 127.3$ U

Flexible budget

variances

Managerial Performance Report: Quarterly Production(in thousands)

Managerial Performance Report

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Actual results

Flexible budget

Static budget

Units produced 3,000 3,000 - 2,400 600 FProduction costs:

Direct materials 927.3$ 780.0$ 147.3$ U 624.0$ 156.0$ UDirect labor 360.0 360.0 - U 288.0 72.0 USupplies 80.0 90.0 (10.0) F 72.0 18.0 UIndirect labor 220.0 210.0 10.0 U 168.0 42.0 UPower 40.0 60.0 (20.0) F 48.0 12.0 USupervision 90.0 100.0 (10.0) F 100.0 - Depreciation 200.0 200.0 - 200.0 - Rent 30.0 20.0 10.0 U 20.0 -

Total Costs 1,947.3$ 1,820.0$ 127.3$ U 1,520.0$ 300.0$ U

Flexible budget

variances

Managerial Performance Report: Quarterly Production(in thousands)

Volume variances


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

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Activity Based Performance Report

• Measures budget variances for each of the overhead activities

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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

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Traditional budgeting: relies on functional-based line items


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

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• 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

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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

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Planning Considerations

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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

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Measures of Capacity Utilization

• Output measures of capacity• Input measures of capacity• Utilization

Utilization = average output rate = 100% maximum capacity

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Deming’s Fourteen Points

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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 fear9. Break down barriers between departments10. Stop haranguing workers

11. Support, help, and improve12. Remove barriers to pride in work13. Institute a vigorous program of education and self-improvement14. Put everyone in the company to work on the transformation

Measuring Performance

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Return on Assets (ROA):

Increase ROA with higher net income

and fewer total assets

Total Assets:Achieve the same

or better performance with

fewer 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 Income:Improve profits with greater revenue and

lower costs

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 Cash Flows:Improve positive cash flows by reducing lead

times and backlogs

Inventory:Increase inventory turnover

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

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Two Ways Quality Improves Profitability

140

• Improved response• Flexible pricing• Improved reputation

Sales Gains via

• Increased productivity• Lower rework and scrap costs• Lower warranty costs

Reduced Costs via

Improved Quality

Increased Profits

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

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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

142

Conclusion

143

cost management basics cost planning

Documents

cost plans

activity cost

cost forecasting

cost controls

cost estimating

cost model

cost planningcost planning

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