Cost Accounting & Financial Planning PDF

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22E26000 Cost Accounting and Financial Planning David Derichs Lecture 1: Designing cost accounting systems History of cost accounting - why is it relevant to know costs?  pricing models  profitability analysis; product-mix decisions  planning; optimal production quantities  production management; real incurred costs versus planned  inventory valuation; most obvious one from the accounting perspective  incentive for employees to motivate them to create more profitable products - increases in overheads; calls for increasingly sophisticated cost allocation  top management salaries  ERP systems; is it worth it, does it affect your product and how  differentiation strategy; requires high customer attention, but is also more costly, adding features to your products to increase recognisability etc. Approaches to cost accounting - all costing systems function in a similar way: 1. general ledger accounting accounts; e.g. salaries, materials, services, S&A , PPE  overhead costs (generally) 2. these costs are to be assigned to something; product, service, customer 3. pick the cost accounting system that is causally linked 4. costs are driven down to e.g. departments 5. then onto the products, using a specified cost driver - 4 approaches to cost accounting:  traditional, volume-based costing methods o 40% of companies still use this traditional approach o overhead cost centres driven to production cost centres (often departments, rather obscure), then the best available measure is used to drive these costs onto the products  activity-based costing (ABC) o activities defined o find out spending per activity o identifying cost objects; why does the organisation operate  e.g. business segments o selecting the activity cost drivers; transaction drivers (measured in actions), duration drivers (more detailed, based on hours), intensity drivers o activity based costing serves as a starting point for operational ABM and strategic ABM (activity-based management)

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o very cost-intensive to incorporate new products, new activities into the costing system (complex system to gain accurate cost information) o subjective, inaccurate data (dealing with humans) o expensive to apply, high effort to keep the model up to date resource consumption accounting (RCA); quantitative, numberfocused approach o overhead costs  resource cost pools  within this cost pool, costs are separated into fixed and proportional  then assigned to the products (in addition to direct materials and direct labour) o resources are grouped based on technology, skill and homogeneity  simpler approach o employs theoretical capacity rather than practical o fixed and proportional; you know what you can change o distinction between primary and secondary costs o uses replacement costs rather than historical costs for depreciation  keeps the whole system more up to date time-driven activity-based costing (TDABC) o resource expenses signed onto operating departments o hourly wage calculated for a process  track or estimate required time o operating department level versus process level; operating department approach only works, if these levels are similar with regards to wage rates  process level is more accurate and coherent o process capacity; how many hours are available  practical capacity rule of thumb: 80-85% versus exact calculation  exact: hours worked, subtract sick days, holidays etc.  special issues in calculating practical capacity; lumpiness in acquitting capacity, seasonal and peakload capacity (charge more in the hourly rate of high season production), capacity that enhances service quality (important customer accounts, special attention  costs should only be assigned to these customers, not distort every account), assignment of unused capacity costs (most likely, not all costs can be assigned  assign rather to a person responsible rather than a specific product)  capacity cost rate = capacity cost / practical capacity (hourly wage of the process)i o process times; how much time is consumed  use of concise time equations with causal what-if formulations = base time + time x number of items + etc. o particularly useful for service organisations

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o strength of the time-driven ABC system regarding variation in tasks; if the process changes, you can just add the new term to the equation (example of new account) industry-specific cost allocation; ABC might not be the right fit for a mass producer  however, what is required is need-based cost allocation differentiation strategy  requires more accurate costing system hotel example; allocating overhead  streamlining the processes a) ABC  capacity; space and time of receptionist (practical capacity, could also be full capacity)  check-in, check- out  two main activities  survey, find out time spent per activity (70-30 relation)  transaction driver; people count b) TDABC  allocate costs to cost pools  survey also required  transaction map; time per different step  customer classification; tourist/leisure or business etc.  different requirements, different time consumption  possible complaints  take additional time

Lecture 2: Strategic Activity-Based Management (ABM) Product mix and pricing decisions - whale curve; how do the products in your portfolio affect to your profitability o percentage of your total products plotted against cumulative profits o plot your products from highest to lowest profit margin o mass-produced, efficiently produced  high profit margins - many companies produce and sell products with negative profitability  identifying these is crucial for improving profitability - product cost structures; how are they formed and how do they differ o product complexity o required labour; human skill or machine o labour intensity of production; time and cost o raw materials; availability (resource scarceness, distance) and cost o acquiring; power in negotiations, efficiency in processes o development costs; extensions or innovations o storage costs and requirements o transport costs and requirements o marketing costs o scheduling product orders and performing first item inspection - improving product profitability through ABM o reprice; customers may not like this change o substitute; a large product portfolio is desired to satisfy customer demands, but outsourcing can be a valid option o redesign o improve production processes o change operating policies

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o invest in flexible technology; may be too costly  thorough analysis required theory of constraints (TOC); maximises throughput  assumes that in the short-term, labour costs and overhead are fixed o focuses only on variable costs o assumes period costs to be fixed; this is not true in the long run  capacity can be shifted  reason behind it is demand or strategy 1. identifying constraints; bottle-necks in machines or processes 2. exploiting the constraint; trying to eliminate the constraint 3. subordinate; focus resources on the constraint 4. elevate the constraint to a new level 5. repeat steps; every process always has a limitation

Customer profitability - the whale curve is relevant here as well; they exist almost everywhere (probably for a reason) - 80-20 rule; 20% contribute a lot to your profits  quite many customers who actually pull down your margin  these customer need to be identified - traditional approach; customer profit = sum of purchased product contribution margins (sales price- variable costs – allocated overhead) o traditional view treats all customers equally o no way to know whether customer A uses more resources than customer B o method works well if products are standardised  products don’t differ significantly between customers - cost-to-serve o works well with a differentiation strategy o differentiation based on service quality, customer focus on processes o comes at a cost; customer most likely has some kind of a costsaving method in mind  supplier has to carry the additional costs o takes customer specific costs into account o these products are usually not essential in business, because they pay a lot for them o low cost-to-serve, high margin; product is a small part of the whole end product or customers with whom you have excellent relationship  competitors also want these customers, cherish these relationships (little gestures, order prioritised) o high cost-to-serve, low margin; these are the customers to get rid of if improvements can’t be made  indirect ‘firing’ by taking resources away  can however, be reference customers or network-building opportunities  new business contacts  learning aspect; joint research projects and other ventures  maintaining market share o initially, internal processes should be improved  cutting costs, effectiveness - how are customers different in terms of costs they cause?

o logistics; transportation and storage o specification; additional design costs, manufacturing o order processes and quantities (JIT, just in time production very expensive to suppliers) o time consumption; high requirements  meetings, calls, email, constant contact o different profit margins of products o special treatment Customer value - net present value for individual customers can also be calculated, learning value can be included etc. - risk imbedded in the long-term  diligence should be done before accepting new customers: o payment risks o reputation damage o risk shifting; e.g. just in time, small order sizes  inventory risk shifted onto supplier - negative or positive lifetime values of customer; NPV and risks Supplier management and relationships - you want to get the required resources for as cheap as possible - possible quality issues  quality check as goods come in - liabilities; who is responsible of payment if something goes wrong  e.g. bad contractors might have already gone bankrupt so you will not get any warranty from them - capacity issues; can the supplier answer grown demand or required batch sizes  two different suppliers require two quality checks etc. LEARNING DIARY: CONTRIBUTION MARGIN APPROACH NOT DISCUSSED IN LECTURE Case discussion: La Grande Alliance - risk of using time to allocate costs  quality of dishes may suffer - in especially high service quality establishments, time-based allocation carries a risk - benchmarking is very important in pricing decisions - product: service, environment, atmosphere, food  all-round experience - fixed menus with fixed prices  a good alternative to hit set target - maximum capacity of customer is rather fixed  most likely, service personnel numbers can’t be altered - chef is the key controller in the restaurant environment (kitchen), captain in the dining room - anchor dish on the menu; the most expensive item to incentivise people to go for the pricier dishes Why is LIDL so cheap? - efficient, simple processes  packages straight to the shelves - private labels

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supplier changes are made more easily, not as rigidly order quantities are large; bulks store layout, customer experience  very simple, basic, less decoration etc. efficient logistics streamlined processes throughout the whole

Theory of constraints (TOC) - can’t be used to organise an entire factory  can be implemented with parts of processes - short-term planning; no cost allocation is actually required Lecture 3: Cost as a basis for pricing Is cost equivalent to price? - determining price in different situations: o competitive pricing; benchmarking to relevant competitors; market-driven pricing o cost plus pricing; mark-up, margin model o price bundling; negotiations o consumer survey if product new to market, research o penetration pricing; low (too low) price as entering the market o price skimming; price discrimination strategy  high price as entering the market, then lowering Reasons for cost-based pricing - no competition, and regulated - simple products; customers don’t care that much - no reference point available; new product, new market, new model etc. - in general: most prices have probably originally been derived with the cost-plus model  cost structures have differed  prices have evolved into market-driven prices as competition has become more prominent Pricing in regulated situations - alcohol, electricity, healthcare, gambling, transportation, sewage, water supply, garbage disposal, postal services etc. (regulated prices in Finland)  natural monopolies - why are natural monopolies regulated o common goods, vital basic needs have to be fulfilled  these have to be offered for everyone at a reasonable price o welfare promotion; restricting harmful behaviour with high alcohol tax etc. o geographical view; some areas are not profitable to operate in but still have to be serviced  e.g. postal services and healthcare o basic functions to ensure cities work; sewage, garbage disposal, transportation etc.  infrastructure needs to be in place  proper regulation gives the society a competitive advantage o high barriers to entry o market structure does not move towards competition in reasonable time

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o competition law alone would not facilitate the market adequately or can’t answer the demand in adequate speed  agency required  regulation why do we have natural monopolies o market is not big enough for many providers  there can not be many suppliers o cost efficiency; large economies of scale o infrastructure comes at a high cost  market is created based on people using the infrastructure provided by one actor (no need for overlapping etc.  more efficient) o often, these industries are state-funded o usually vital for society (telecommunications, electricity, sewage etc.) o if these natural monopolies are not in place, companies could charge what they want for these vital needs  ‘free lunches’ available  the need for regulation o traditional solution is state ownership, though comes with various problems  inefficient management and scheduling  no pressure from the top  employees have highly protected positions  might be good or bad  hidden taxation; should be more transparent

Regulation of natural monopolies - public supervision; preventing disputes - suitable profit; profit has to cover investments, satisfy stakeholders  negative margin is not acceptable  has to fit the optimal cost structure but also be in balance with protection of societal interests - capital invested; additional required investments have to be taken into account - incentivise investment - effective regulation created wellbeing for society, welfare Common costs terminology in the EU - market liberalisation wave, EU-driven - determining legitimate price o based on costs, ensure living wage and appropriate working conditions o public procurement in large-scale, governmental projects o impact on society o weighted average cost of capital (WACC); including the risk characteristics of the company to determine justified returns - overarching legal concept: average avoidable cost (AAC); average of the costs that could have been avoided if the company had not produced a discrete amount of output o in most cases, AAC and the average variable cost (AVC) will be the same, as often only variable costs can be avoided

o an appropriate starting point for assessing whether a dominant undertaking incurred or is incurring avoidable losses  if overcharging incurred? Long Run Average Incremental Cost (LRAIC) - given certain initial conditions, LRAIC calculated the cost of providing a predefined increment (increment = what is charged for the product) - a cost modelling approach; how much to charge - from a long-term perspective, what are the costs of adding a service/product to an existing portfolio of services/products  not historical costs, not only variable costs but also some part of fixed costs are included - a method to prevent monopolies overcharging society for the service - shared costs; initial products/services determine whether these should be included when determining the cost of the increment - initial conditions; the original product situation  if shared costs already incur without the new proposed product/service, then not taken into account - if adoption of multiple products is already planned but occur In different time frames, then shared costs can indeed be shared between these products - increment; key is the initial definition o average costs (LRAIC) versus single product allocation (LRIC) o the average cost is essential to project into the future, not only historical costs o example A B C  gradual implementation  average costs ! o determining the incremental cost (price):  capital invested  WACC  permitted return  permitted price  capital invested; balance sheet adjustment  current value has to be determined, replacement value at the component group level (usually done by third parties to avoid fingerpointing, example of the gas industry)  WACC determination; risk premium  supply risk, currency risk, market risk, regulatory risk, liquidity risk (company not publicly traded), tax benefit of debt financing  permitted return = capital invested x WACC +/- efficiency incentives (higher efficiency increases permitted return) – supply security incentive (if supply is not secure for customers, decreases permitted return + any other incentive  permitted transmission price = permitted return + cost -

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definition of costs o current costs, not historical o only costs of an efficient operator are taken into account like this o all costs should be considered variable on the long run  decisionmaking should stride for efficient operations LRAIC in action

o top-down approach; starting with information provided by companies (e.g. Helsinki gas market)  fully distributed cost – historical cost accounting  fully distributed cost – current cost accounting o bottom-up; first model the ideal company and based on this you calculate the costs (telecommunication regulation)  scorched Earth approach (greenfield scenario); completely new network, 100% efficiency  a completely new company  modified scorched model; take into account limited flexibility  adjusting to the constraints in place Case discussion: Boston Children’s Hospital Lecture 4: Tactical Planning Recap - Cost systems often prescribed from the regulatory environment - Regulation costs companies: pay a consultant, establish a task force to complete work demanded by the regulatory framework Tactical Planning - Strategies are used to conquer a market, a product segment, defend a segment etc. I. Why plan? Why is planning becoming more and more crucial for long-term success? - Customers are pickier, more products to choose from - In a case of an investment: don’t know how the future looks – many uncertainties (political landscape etc.), knowing the risks is crucial - Product lifecycles are becoming shorter - Groundbreaking innovations much more common - Transparency – requires effective governance and to govern properly thorough forecasting is essential - Differentiation Typical planning process - Board: requests a plan, shareholders want information and security - Senior management: board goes to the management with a target – e.g. revenue growth, assess a risk (e.g. competitors) - Corporate finance: targets delivered to the corporate finance division – how to operationalize these targets?  modelize objectives - Business line management: models distributed to business line management - Departmental management: models further distributed to departmental management -  if target is e.g. profit increase, this means cost reductions and potentially firing employees, people lose ownership in the numbers as they cannot follow them anymore and have no idea how to control them

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 this often follows a fight between senior and lower management – a lot of reviewing and revising until the budget is approved

Traditional planning: the budget problem - Based on last year +/- a percentage - Sandbagging - License to spend - Quasi-fixed - Arbitrary cuts Expensive to produce: 6-month process, people involved in it that could do actual work How we should do it - Strategic plan is devised: senior management task – crucial, a proper strategy with underlined fundamental...