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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

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agenda

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

slide4

Capture and Valuate Data

    • Accurate, timely and relevant data
    • Connecting operational output/performance data to financial data
    • Allocate Overhead

Cost

Accounting

  • Cost Planning
    • Set Cost Targets and Efficiency Goals
    • Compute Standard Rates

Cost

Planning

Cost

Analysis

Cost

Management

Process

  • 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

  • Cost Controlling
    • Move to action based on analysis
    • Change targets
    • Change resources
    • Change quality

Cost Management Involves

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?
what is cost1
Basic elements of cost:

Raw materials

Labor

Indirect expenses/overhead

What is cost?
cost converting and measurement of work

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

slide8

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

Cost

Controlling

what is cost planning
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
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
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.

Guiding Principles
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.

Cost Planning Highlights
what is cost planning1
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?

What is cost planning?
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.

Cost Planning Summary
planning vs actual data
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
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
computing rates1
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
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

Computing Rates Examples
computing rates2
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

Computing Rates
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 Rates
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.

Labor Rate Example
establishing standard rates
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
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.
performance measurement
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 measurement1
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

productivity

Units produced

Input used

Productivity =

Productivity
  • Measure of process improvement
  • Represents output relative to input
  • Only through productivity increases can our standard of living improve
productivity calculations

Units produced

Labor-hours used

Productivity =

1,000

250

= = 4units/labor-hour

Productivity Calculations

Labor Productivity

One resource input  single-factor productivity

multi factor productivity

Output

Labor + Material + Energy + Capital + Miscellaneous

Productivity =

Multi-Factor Productivity
  • Also known as total factor productivity
  • Output and inputs are often expressed in dollars

Multiple resource inputs  multi-factor productivity

collins title productivity

Old System:

Staff of 4 works 8 hrs/day 8 titles/day

Payroll cost = $640/day Overhead = $400/day

New System:

14 titles/day Overhead = $800/day

Collins Title Productivity
collins title productivity1

Old System:

Staff of 4 works 8 hrs/day 8 titles/day

Payroll cost = $640/day Overhead = $400/day

New System:

14 titles/day Overhead = $800/day

8 titles/day

$640 + 400

Old multifactor productivity

=

Collins Title Productivity

= .0077 titles/dollar

14 titles/day

$640 + 800

New multifactor productivity

=

= .0097 titles/dollar

measurement problems
Measurement Problems

Qualitymay 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

slide38

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
slide39

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 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: Activity Types
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 Do
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

Master Data: Things You Track
quality function deployment
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
what is forecasting

??

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

Seasonal peaks

Actual demand line

Demand for product or service

| | | |

1 2 3 4

Time (years)

Components of Demand

Trend component

Average demand over 4 years

Random variation

trend component
Trend Component
  • Persistent, overall upward or downward pattern
  • Changes due to population, technology, age, culture, etc.
  • Typically several years duration
seasonal component
Seasonal Component
  • Regular pattern of up and down fluctuations
  • Due to weather, customs, etc.
  • Occurs within a single year
cyclical component

0 5 10 15 20

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

M T W T F

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

Actual observation (y-value)

Deviation7

Deviation5

Deviation6

Deviation3

Values of Dependent Variable (y-values)

Deviation4

Deviation1

(error)

Deviation2

^

Trend line, y = a + bx

Time period

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

| | | | | | |

1 2 3 4 5 6 7

associative forecasting
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 forecasting1
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
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
multiple regression analysis
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
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

Acceptable range

Lower control limit

Time

Tracking Signals
adaptive smoothing
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
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
Seasonal Variations in Data

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

seasonal variations in data1
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
Capacity and Scale
  • 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 scale1

250-bed hospital

750-bed hospital

500-bed hospital

Average unit cost (dollars per patient)

Economies of scale

Diseconomies of scale

Output rate (patients per week)

Capacity and Scale
benchmarking1
-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:

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

Benchmarking
types of benchmarking
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
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

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 costs1

B

Lowest marginal costs

Marginal Costs

Total cost

Total

(£)

C

High marginal costs

A

High marginal costs

Output

average costs
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
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
  • 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
what does earned value mean
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
the balanced scorecard
The Balanced Scorecard

Financial Perspectivecreating organizational valuefor owners/shareholders

Customer perspective

processadding value for customers

Internal business

processensuring efficiency andquality in the value chain

Strategy

Learning and growthinvesting in organizationalinfrastructure

the balanced scoreboard
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

limitations of the balanced scoreboard
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
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

slide89

Inputs

Outputs

Conversion

“Work”

The Management Processes

Resource

Managers

Operational

Managers

$

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

estimating product costs for planning decisions
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 control2
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
the role of budgeting in planning and control3
The Role of Budgeting in Planning and Control
  • 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
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’

preparing the operating budget1
Preparing the Operating Budget

Schedule 2 (in thousands)

Starting point for ‘Direct Materials Purchases’ budget

Starting point for ‘Direct Labor’ budget

preparing the operating budget2
Preparing the Operating 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

preparing the operating budget3
Preparing the Operating Budget

Schedule 4 (in thousands)

Starting point for ‘Overhead’ budget

Goes to ‘Cost of Goods Sold’ budget

preparing the operating budget4
Preparing the Operating Budget

Schedule 5 (in thousands)

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

Goes to ‘Cost of Goods Sold’ budget

preparing the operating budget5
Preparing the Operating 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

preparing the operating budget6
Preparing the Operating Budget

Schedule 7 (in thousands)

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

Goes to ‘Budgeted Income Statement’

preparing the operating budget7
Preparing the Operating Budget

Schedule 8 (in thousands)

Goes to ‘Budgeted Income Statement’

preparing the operating budget8
Preparing the Operating Budget

Schedule 9 (in thousands)

Goes to ‘Budgeted Income Statement’

preparing the operating budget9
Preparing the Operating Budget

Schedule 10 (in thousands)

Goes to ‘Budgeted Income Statement’

preparing the operating budget10
Preparing the Operating Budget

Schedule 11 (in thousands)

operating budgets for various organizations
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
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

preparing the financial budget1
Preparing the Financial Budget

Schedule 12 (in thousands)

preparing the financial budget2
Preparing the Financial Budget

Schedule 12 (in thousands)

preparing the financial budget3
Preparing the Financial Budget

Schedule 12 (in thousands)

preparing the financial budget4
Preparing the Financial Budget
  • Budgeted Balance Sheet
    • Current (actual) balance sheet
    • Integrate data from all other budgets
preparing the financial budget5
Preparing the Financial Budget

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
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
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
flexible budgets for planning and control
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
flexible budgets for planning and control2
Flexible Budgets for Planning and Control
  • 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 reports1
Managerial Performance Reports
  • Have flexible budget variances
    • Actual results vs. flexible budget
    • Examines efficiency
  • Has volume variances
    • Static budget vs. flexible budget
    • Examines effectiveness
flexible budgets for planning and control3
Flexible Budgets for Planning and Control
  • 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
Activity Based Performance Report
  • Measures budget variances for each of the overhead activities
activity based budgets
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
activity based budgets1
Activity Based Budgets

Traditional budgeting: relies on functional-based line items

activity based budgets2
Activity Based Budgets

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

activity based budgets3
Activity Based Budgets
  • 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
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 capacity
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
Measures of Capacity Utilization
  • Output measures of capacity
  • Input measures of capacity
  • Utilization

Utilization = average output rate = 100%

maximum capacity

measuring performance1

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

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

Net Cash Flows:

Improve positive cash flows by reducing lead times and backlogs

Total Assets:

Achieve the same or better performance with fewer assets

Fixed Assets:

Reduce the number of warehouses through improved supply chain design

Inventory:

Increase inventory turnover

Measuring Performance
process considerations
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

Sales Gains via

  • Improved response
  • Flexible pricing
  • Improved reputation

Improved Quality

Increased Profits

Reduced Costs via

  • Increased productivity
  • Lower rework and scrap costs
  • Lower warranty costs
Two Ways Quality Improves Profitability
resource planning
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
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