Lecture 9 Flashcards
Relevant costs and revenues:
Not all costs and revenues are relevant
Relevant:
1) Relevant costs and revenues:
Expected future costs or revenues
Need to differ among alternatives
2) Opportunity costs
-Not always easily visible
3) Qualitative factors
E.g. Customer satisfaction, reputation
Relevant costs and revenues:
Not all costs and revenues are relevant
Irrelevant
1) sunk costs
Past (historical) costs often irrelevant
(e.g. investment in plants, machines): cannot be changed
Costs “sunk” in the short-run may “surface” in the long run
2) Unit costs
Problematic as they can contail fixed (sunk?) costs
What other factors (besides financials) should wooden memory consider
E.g. reputation effect for existing and future relations
Business strategy is key for evaluating the effect of these decisions
How would decision change if current production was already 100 000 i.e. already at (near) capacity?
If production capacity is extended: “fixed” costs (e.g. rent, leases) are not really fixed any more –> previously irrelevant costs become relevant
If other business is sacrificed: Compensation for lost business becomes relevant (add opportunity costs as relevant costs)
Outsourcing Pros:
Lower costs due to competitive advantage of suppliers
Location (e.g. lower wages)
Skills (more advanced technology or knowledge)
No fixed costs in own books
Leaner production
Focus on core activities and strategic strengths
Outsourcing cons:
Proprietary costs (losing business secrets)
Dependencies (e,g, loss of knowledge/experties that cannot easily be “reactivated”)
Local/ communal responsibility: can mean laying off employees
Employee identity and corporate culture
Reputation risks
Quality concerns
Quality: what is important
Quality can be a way to guarantee customer satisfaction (which increases sales)
QUality is a competitive advantage; reduces costs and increases revenue
Types of quality
Conformance quality and design quality
Conformance quality
Is the performance of a products/services according to the design & prodct specifications
Design quality
How close do characteristics of products/services match needs and wants of customers
How can we keep track of quality
Develop financial and non financial measures to monitor both types of quality
Costs of quality:
Control costs: include
Prevention costs
Appraisal costs
Failure of control costs: include
Internal failure costs
External failure costs
Control costs
Cost incurred to prevent low quality products
Prevention and appraisal costs
Failure of control costs
Costs arising as a result of low-quality products
Internal failure costs
External failure costs
Prevention costs
Eg: design engineering
Supplier evaluations
Training
Appraisal costs
Eg:
Inspection
Product testing
Internal failure costs
Eg
Rework and retests
Breakdown maintenance
Delays
External failure costs
Customer support
Liability claims
Trainsportation costs
opportunity costs
Loss of potential gain from (the best of) the other alternatives when one alternative is chosen
Theory of constraints
A technique where the primary goal is to maximize throughput while simultaneously maintaining or decreasing inventory and operating costs
Theory of contraints: cycle
1) identify the system constraints (is the constraint internal (e.g. in production, engineering or planning) or external (e.g. in the market)?
2) Decide how to maximize the output from the constraint
3) subordinate everything else to this decisions
(the production capacity of the bottleneck resource should determine the production schedule for the organization)
4) Eleviate the systems bottlenecks:
Take actions to increase bottleneck efficiency and capacity (e.g. training, additional machines, outsourcing) after taking into account the cost of such actions
Throughput accounting
Focus on the contrained resource
The objective is to increase throughput contribution minus the incremental costs of alleviating constraint/s
Throughput contribution (=price - direct material cost)
Role of the management accountant
Calculate the throughput contribution
Calculate the identify relevant and irrelevant costs
Conduct cost-benefit analyses of alternative actions to increase efficiency and capacity
Complexities
More machines and products can significantly increase complexity
Different orders (of prioritizing lucrative products) possible
Analytical or simulation
Net present value (formula)
Cash inflows (discounted) - Cash outflows (discounted)
= SUM(cash inflows/(1+r)^n)) - SUM(cash outflows/(1+r^n))
What is the “interest” rate (cost of capital rate) for the NPV calculation
Opportunity costs
E.g. actual interest rates
Internal rate of return (IRR)
Rate at which NPV = 0
I.e. Solve equation for r given information on cashflows and timing
0 = SUM(cash inflows/(1+r)^n) - SUM(cash outflows/(1+r)^n)
IF
Cost of capital > IRR –> Project is not lucrative (because NPV will be <0)
IRR > cost of capital –> Project is lucrative (because NPV will be >0)
Return on investment: Formula
ROI = Income/investment
Income: net profit or operating profit
Investment: Total assets or some specific assets
Widely used measure
ROI is an intuitive “accounting” rate of return (often compared with average investment return)
ROI for new project <–> Average investment return (for current projects)
Performance measures: ROI (II)
Disadvantages:
Ratio (denominator or numerator) effects
Expensive investments might not be undertaken despite potentially high absolute profit
Managers might decide on unwanted reductions of the asset base
Performance measures: ROI (II)
Disadvantages:
Compensation on average ROI achievement might induce gaming
Goal congruence issues: lucrative projects rejected when return is lower than the current average ROI
Managers might shift costs and benefits to manipulate accounting numbers used to calculate ROI
Short term focus: may lead to reduction of investments with long term benefits
Performance measures: ROI (II)
Disadvantages:
When used to compare alternative investments
Investment holding periods are ignored (no adjustments for time value of money)
Riskiness of the investments are not considered
Residual income
Income - r*operating capital
r: the cost of capital rate
Economic value added: (EVA)
Idea: operating profit after taxes needs to be higher than costs of debt and equity
EVA = NOPAT - ((Total assets - current liabilities) * WACC)
NOPAT = net operating profit after tax
Different metrics say different things about performance: ROI, RI, EVA
Can only be applied to investment centers
Are financial measures
Not forward-looking (focus on past performance)
No direct link with strategy
Aggregated and general
Different metrics may lead to different conclusions about performance
Alternative/extension: non financial measures
Can be individual aligned with strategy and strategic needs
Forward-looking: “Leading factor” (they (should) lead to future financial performance)
Balanced scorecard (BSC)
Translates strategy into a comprehensive set of performance metrics
Strength in making (causal) connections between non-financial and financial measures
Financial KPI:
To succeed financially, how should we appear to our shareholders
Internal KPI
To satisfy our shareholders and customers, what business processes must we excel at?
Innovation and learning KPI
To achieve our vision, how will we sustain our ability to change and improve
Customer KPI
To achieve our vision, how should we appear to our customers
Besides the need to be theoretically good, performance measures need to be:
understandable
Acceptable
Economically feasible
Besides the need to be theoretically good, performance measures need to be:
Understandable
Clear metrics formulated in a simple and comprehensible way
Calculations that are understandable and intuitively clear for employees
Clear and intuitive purpose
Understandability is required for acceptance
Besides the need to be theoretically good, performance measures need to be:
acceptable
often performance metrics are introduced when a company is restrucutred
There is generally resistance towards “new” performance metrics
Sometimes: theoretically superior, but rejected metrics < Theoretically inferior, but accepted metrics
Besides the need to be theoretically good, performance measures need to be:
Economically feasible
Costs of implementation
Costs of capturing performance
costs of evaluation
what transfer price leads to the optimal coordination and aligns interests
TP = MC
