Cost estimation methods
- Account analysis
This estimates cost functions by classifying cost accounts in the subsidiary ledger as variable, fixed or mixed with respect to the identified level of activity. Typically, managers use qualitative rather than quantitative analysis when making these cost classification decisions.
- Engineering method
This estimates cost functions by analyzing the relationship between inputs and outputs in physical terms, for example consider cloth making, the output of material, labour and other factors is measured in square yards of cloth.
Conflict that may arise from the following functions of a budget
- Planning versus motivational roles
Demanding budgets that may not be achieved may be appropriate to motivate performance, but they are unsuitable for planning purposes. For planning purposes a budget should be set based on easier targets that are expected to be met.
Planning and performance evaluation
For planning purposes budgets are set in advance of the budget period based on an anticipated set of circumstances on environment. Performance evaluation should be based on comparison of actual performance with an adjusted budget to reflect the circumstances under which the managers actually operated. In practice many firms compare actual performance with the original budget (adjusted to the actual level of activity, that is, flexible budget) but if the circumstances envisaged when the original budget was set to have changed, then there will be a planning and evaluation conflict.
Purpose of budgeting
- Planning for the future in line with the objectives of the organization
- Controlling costs by comparing the budget with the actual results
- Co-ordination of the different activities of the business ensuring managers are working towards a common goal
- Communication – budgets communicate targets of the organization to individual managers
- Motivation – budgets can motivate managers by encouraging them to beat targets. Bonuses are often used on beating targets.
- Evaluation – the performance of managers is often judged by looking at how well the managers performed against the budget
- Authorization – budgets act as a form of authorization of expenditure
Steps followed in designing activity based cost (ABC) systems
Step 1: identify activities
Activities are identified by carrying out an activity analysis. Activities are composed of the aggregation of units of works or tasks and are described by verbs associated with tasks. For instance purchasing of materials might be identified as a separate activity but may consist of many different tasks such as receiving a purchase request, identifying suppliers, preparing purchase orders mailing purchase orders and performing follows ups.
Step 2; Assigning cost to activity cost centres.
Cost of resources consumed over a specified period must be assigned to each identified activity. The aim is to determine how much the organization is spending on each of its activities.
Step 3: Selecting appropriate cost drivers for assigning the cost of activities to cost objects.
In order to assign cost attached to each activity cost centre to products, a cost driver must be selected for each activity centre. Cost drivers used at this stage are called activity/cost drivers. Their cost of measurement should also be taken into account.
Step 4 : Assigning the cost of activities to products.
This stage involves applying the cost driver rates to products. Therefore, the cost driver must be measurable in a way that enables it to be identifies with individual products.
Other factors that influence the choice of order quantity.
- Shortage of future supplies.
Any eventualities that may pose some uncertainty of future supplies for example a strike may influence the order quantity.
- Expected future price increases
An anticipated price increase in future would influence the quantity ordered.
Certain types of stocks are subject to obsolescence e.g. due to change in technology or change in fashion. This may influence the order quantity.
- Steps to reduce safety stock
Attempts to reduce safety stock held may influence the quantity of stock to be ordered, etc.
Limitations of the application of expected value approach in decision making
- It ignores risk. Decisions should not be based on expected value alone but should be used in conjunction with other measures of dispersion that measure risk.
- Expected value approach is a long average payoff in decision making. It’s therefore suitable to problems of a repetitive nature.
- Expected value is based on averages of outcomes and therefore it’s unlikely that the expected value will occur.
Applications of simulation
- Simulating inventory costs
- Simulating expected contribution with expected profit
- Simulating project completion time
- Simulating machine failure rate
Non-financial performance indicators.
- Personnel performance
Number of complaints received.
Training time per employee.
Days lost through absenteeism.
Set up times.
Output per employee.
Manufacturing lead times.
Number of day’s inventory is on hand/stock holding period.
Perspectives of balanced score card
- Customer perspective
This perspective gives us to targets which matter to customers. For example cost, quality delivery, inspection of the goods and handling of goods or customers. If customers are not satisfied, they will eventually find other suppliers that will meet their needs.
Poor performance from this perspective is thus a leading indicator of future decline, even though the current financial picture may look good.
- Business process perspective
This perspective aims to improve internal process and decision making. It is also known as internal business processes. Metrics based on this perspective allows the managers to know how well their business is running and whether its products and services conform to customer requirements.
- Financial perspective
This covers traditional measures for example growth, shareholders value among others.
According to this perspective, timely and accurate funding data will always be a priority and managers will do whatever necessary to provide it.
- Learning and growth perspective
This perspective includes employee training and corporate cultural attitudes related to both individual and corporate self-improvement. In the current climate of rapid technological change, it is becoming necessary for knowledge workers to be in a continuous learning mode.
Advantages of benchmarking
- It improves performance by learning from the experience of others.
- Helps an organization understand its own business operations because of the detailed analysis that has to be carried out.
- Comparison can be made with direct competitors or the best external predictor.
- Helps to understand the cause and effect and the relationship between processes.
Importance of non-financial performance measures
The modern service sector is extremely competitive and as a consequence if a business is to succeed, it needs to ensure that it is both efficient and that it satisfies the needs of its customers.
Financial performance is important but this is described as a “lagging measure” in that it reports on what has happened. Failing to meet targets can mean that profits are not achieved and that inadequate current returns are obtained. However short term action to improve current financial performance might, in the long-term be at the expense of the company’s interests. This is why modern thinking suggests that non-financial measures may be more appropriate in assess performance. Non-financial “leading” measures indicate how well, the company is doing things that can lead to future profits.
Non-financial performance measures
- One measure could consider customer satisfaction such as number of complaints and or recommendation. In the short term saving money by cutting back on customer service might lead to long term loss of business due to a declining reputation.
- Another measure might look at the number of new routes and events packages offered by the branch. In the short term these would cost money to set up but in the long term they may lead to new business by achieving a competitive edge.
Problems with using ROI
The use of single financial measure to Judge the performance of branches has the following problems.
Because the measure is short-term and looks at the results of a single year, there is no incentive for branches to improve. They will invest in long-term projects and will be inclined to hold on to assets too long so that their carrying amount reduces and ROI increases.
No consideration is given to other non- financial measures will be critical to the company’s success, such as customer satisfaction, staff motivation etc.
The· costs of each branch will generally be fixed: controlling the costs will not necessarily make the branches more successful. For example costs could be cut by using less experienced staff or cheaper teaching materials, but this is likely to harm the long-term success of the business
Because the branches rent their premises, they will have very few non-current assets (desks, chairs, screens, etc.) and therefore ROI will always be high. The managers will therefore not be motivated to improve performance further.
The sue of national target ROI will not take account of local environment factors which will be different for each branch (such as the level of competition, power of customers, etc.).
Managers may not introduce profitable courses if the ROI on the course is below their existing ROI, even though the course may provide a return above the company’s overall target ROI.
Overall, the use of ROI as the company’s sole performance indicator will not help the business to obtain its goals of development and growth.
The balanced scorecard approach
The balanced scorecard approach will help the business because it recognizes the importance of both financial and non-financial performance. It sets performance indicators and targets for both these areas.
The balanced scorecard looks at four areas which are crucial to the success of the business.
Financial perspectives. It will be important that the company is performing well enough both to satisfy shareholder requirements and to fund future growth. It will also need to complete effectively in its market’s to ensure it can maintain its current market ratio.
Customer perspectives. One of the critical success factors for the business will be how it is
perceived by its customers. There will be four key areas here – customer satisfaction, customer loyalty, customer acquisition, and market awareness of the company. It needs to be measured whether branches are performing well in these areas.
Internal business perspectives. If AFB is to be market leader, then in order to satisfy customers and shareholders an internal structure and framework need to be in place which allows this to happen. This will include having adequate facilities for customers, motivated staff and quality services.
Innovation and learning prospective. For the company to satisfy its development and growth goals it will need to be innovative (introduce new products etc.) and encourage staff to keep up to date with technical changes within their area of expertise (tax, law changes, etc.). This will be needed in order both to maintain customer satisfaction and to create value for other stakeholders in the business such as Jim Buxton and his staff.