Lecture 9 Flashcards
Decisions making steps
- Determine the strategic issues
- Specify the criteria and identify
the alternative actions - Analyse relevant costs
a) Identify & collect relevant info
b) Predict future values of
relevant costs and revenues
c) Consider strategic issues
- Select and implement the best
course of action - Evaluate performance
Theory of constraints :
‘A technique where the primary goal is to maximize throughput while simultaneously maintaining or decreasing inventory and operating costs.’
Throughput Accounting (based on Theory of Constraints)
Focus on the constrained resource:
The objective is to increase throughput contribution minus the incremental costs of alleviating constraint/s.
Throughput contribution (= Price– Direct Material Cost)
Assumption: costs other than DM not variable
Role of the management accountant:
Calculate the throughput contribution
Identify and calculate the 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 solutions possible Throughput Accounting (based on Theory of Constraints)
Relevant Costs and Revenues: Recap
Relevant Costs and Revenues: Recap
Compare the alternative possible actions with a future orientation
Consider the incremental costs or savings
- Focus on the cost and revenues that are relevant to the decision
- ## Do not forget potential long-term effects (e.g. credibility of prices with customers, learning)
Check for any opportunity costs
E.g. Not producing means freed-up capacity that can be used for other things; production can
replace the production of other (lucrative) products
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Do not include sunk costs (not relevant for future decisions and equal across alternatives)
E.g. Plant facilities are there and paid for, regardless of whether or not we an additional offer is accepted
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Check whether bottlenecks or constraints play an important role and deal with them
Discounted Cash Flow (DCF)
Present value = 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤/(1+𝑟)^𝑛
Net present value (NPV) = Cash inflows (disc.) – Cash outflows (disc.)
=
Σ (𝐶𝑎𝑠ℎ𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠/(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)
0
- Rate at which NPV = 0
- i.e. Solve equation for r given information on cashflows and timing
Σ (𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠/(1+𝑟)^𝑛)
-
Σ (𝐶𝑎𝑠ℎ𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠/(1+𝑟)^𝑛)
ROI (Return on Investment:)
ROI = Income/Invested Capital
or
ROI = OPerating income / Avergae operating assets
ROI is an intuitive “Accounting” rate of return (often compared with
current average investment return)
Disadvantages of 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
Compensation on average ROI achieved 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 (e.g. R&D)
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 and EVA
𝑹𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝑰𝒏𝒄𝒐𝒎𝒆 =
𝑰𝒏𝒄𝒐𝒎𝒆 − 𝒓 ∗ 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
Residuale income = Operating income - (rate of return required * average operating asset)
-> r : the cost of capital rate
Performance Measures: Which One?
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
Alternative/extension: non-
financial measures
* Can be individually 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
Leading Measure -
A variable whose change is associated with a later
change in another (lagging) variable. On-time delivery leads to improvements in customer satisfaction.
Lagging Measures -
A variable whose change is associated with a previous change in another (leading) variable. Improvements in customer satisfaction lag behind on-time delivery.
Besides the need to be theoretically good, performance measures need to be…
Clear metrics formulated
in a simple and
comprehensible way
Calculations that are
understandable and
intuitively clear for
employees
Clear and intuitive purpose
Often, performance
metrics are introduced
when a company is
restructured
- There is, generally,
resistance towards “new”
performance metrics
- Costs of implementation
- Costs of capturing
performance - Costs of evaluation
Throughput contribution:
Sales revenue – Direct material costs
