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1: Profit
Profit is a pivotal concept in business, and this is why it is the first one in this book. It measures the economic value generated by an activity. It is defined as the difference between revenues (the value of resources obtained from customers in exchange of products and/or services) and costs (the value of resources used/consumed to generate revenues). The profit equation can be expressed as follows: Profit = Revenues Costs Or as: Profit = Revenues Expenses
Illustration 1.6 presents graphs of a fixed cost and a variable cost. The x-axis is the volume of activity (for example, the number of tanks of ice cream sold). The y-axis is total cost. The first box shows the cost behavior of a resource whose total costs do not vary with the number of tanks of ice cream, while the second box illustrates exactly the opposite. The first box illustrates a fixed costs and the second illustrates a variable cost.
that a resource has a value. A gift may look like it has zero cost because nothing has been paid for it many people think this way, despite the flaw of this reasoning. While the gift is free, it has an opportunity cost, usually very close to the price paid by the buyer. There are two types of resources, thus two types of costs. There are resources that are fully consumed in a period to generate revenues called expenses. For example, the salary of marketing, accounting and human resource managers are expenses. Once their time has been consumed, it is gone. These costs are expenses because they reflect resources that are fully consumed and, therefore, do not have future value. There are also resources called assets that have not been fully consumed in a period to generate revenues. For example, the equipment to produce ice-cram is an asset because it is gradually used until the end of its life. A factory is another example of an asset because it is used to produce in the current period, but it still has value for future periods. The costs of these resources become assets of the company when they are acquired. Because assets are used in future periods, they have value going into the future. In short, whether costs are expenses or assets depends on if the resource is fully consumed during a specific period or it still has value at the end of this period. Concept 2.1: Indifference point
merchandising companies often represent an important use of cash since these types of organizations usually rely on sizeable fixed assets such as manufacturing plants or warehouses for their operating activities. In certain cases, the acquisition of intangible assets like patents and rights might require substantial amounts of cash. The last section of the cash flow statement describes financing activities. It includes transactions made with creditors and shareholders such as the reimbursement of loans, issuance of new equity, repurchase of shares, or payment of dividends.
reflects this fact. Otherwise the ROA of two identical companies would differ simply because one has more debt and the other more equity. The second ratio called return on equity (ROE) evaluates the financial performance from the owners perspective. It is defined as net profit divided by equity, and it indicates the profitability for the owners of the company. In this case net profit is used because equity holders receive the net profit of the company (after paying all expenses including interest and taxes).
Concept 4.1: Performance objects up Concept 4.3: Cost pools, allocation bases and allocation rates
Illustration 4.3 describes the steps to identify direct and indirect costs.
Concept 4.2: Direct and indirect costs up Concept 4.4: Job-order costing system
customers but aims at discovering their deep preferences and buying behavior. Value-based pricing requires a thorough analysis of actual and future market trends.
The 3Cs model is a strategic framework that fundamentally emphasizes the importance of understanding the internal and external business environment. It is based on three factors: costs, customers and competitors. The model aims to encourage companies to bring more value than their competitors at a lower cost to develop and maintain a competitive advantage. It also highlights the trap of being stuck in the middle between companies emphasizing cost and those emphasizing differentiation. This positioning of not pursuing a clear strategy is often hard to sustain.
The first one is to decide. Every time managers face a decision, they should apply the concept of relevant costs and revenues since they reflect expectations about the future cash flows of different alternatives. Relevant costs and opportunity costs go together. The cash flow of the second best alternative is an opportunity cost. The second purpose of cost information is to evaluate the long-term profitability of product and services. This requires the use of a cost system because it estimates the value of the resources used to do something like performing a task, running a department, manufacturing and distributing products, or serving a customer. With cost information, managers are in a better position to make sure that the selling price of products and services pay for the variable (usually the only short term relevant costs) and fixed costs. The third purpose is to plan for the future and evaluate how events are unfolding. Once the management team has decided on a course of action, periodic evaluations should be conducted to assess the situation against the plan and change the course of action if needed. In fast moving markets evaluation has also become crucial for encouraging learning. The fourth purpose is to provide input to financial accounting. Companies have to value inventories and cost of goods sold in their financial statements. This requires the estimation
of costs following financial accounting principles (rules). Actually, this purpose was very important during most of the twentieth century, and decision-making and profitability evaluation were basically ignored in managerial accounting training. Concept 6.1: Relevant costs and
as the company stays in the same location. If the company wants to lower this cost, they would have to relocate. In contrast, discretionary costs are costs that can be adjusted relatively quickly. The costs of marketing, training, exploration of new ideas are typically discretionary costs because managers have the power to determine them. They are not variable costs because they do not change with volume, so are often treated as fixed. Another concept associated with committed and discretionary costs is that of engineered costs. It is usually applied to variable costs and simply means that there are certain costs that automatically accompany a certain decision. For example, if a table manufacturer decides to sell an additional 100 tables, the material and labor costs will automatically increase. If this manufacturer decides not to sell the additional tables, then these variable costs do not apply. This is why they are relevant: they are engineered into the decision. Illustration 6.7 presents an approach to identify committed, discretionary and engineered costs.
Illustrations7.10 describe the calculation and the treatment of fixed cost allocation differences.
Companies with process costing usually have various production stages. An apparel company may have cutting, sewing, and packaging activities, while a chemical company may have mixing, heating, cooling, and cutting stages. At each stage, resources are added to the work in process and costs are recorded. Illustration 7.11 maps a typical process.
Costs that are added at each stage are called conversion costs. Concept 7.3: Cost allocation differences
Studies of business practices show that financial plans may play five distinct roles (Illustration 8.3):
Market size - markets for products and services experience a life cycle just as humans and companies do. A market life cycle has different stages including development, growth, maturity, and decline.
Market share - a more controllable source of growth is a company's ability to increase its share of the market. Market share increases when a company does better than its competitors.
New markets - a third source of revenues is expansion into new markets. These markets can be regions where the company does not already sell its products or markets for which an innovative company develops new products.
Committed costs are easily estimated because they are known and rarely change in the short term.
Engineered costsare based on other assumptions in the profit plan like volume, price of inputs and productivity.
Discretionary costs are harder to plan; managers can set their level with few restrictions. Illustration 8.13 summarizes the top-down financial planning that results in the expected profit.
To fully evaluate the economics of a strategy using financial plans, a planned profit should be stated in relation to the investment needed to achieve it. Measures such as return on investment and residual income are useful to this end. Various investments may be required to execute a new strategy. For operations to grow, companies may need to invest in fixed assets such as new machinery and in current assets such as increases in inventories and accounts receivable. Each strategy should come with an investment plan, detailing the increase in assets that the strategy requires. Growth is usually contingent upon new investments so they should be carefully analyzed. To evaluate the attractiveness of a financial plan using residual income, the cost of capital is needed. The easiest solution is to use the existing cost of capital, assuming that the company will be financed in the same way as it was in the past. With all this information, the strategy can be estimated from an economic perspective as follows: Planned residual income = Planned Profit - (Planned Investment * Cost of capital) Since investments bear their fruits over a long period of time, strategic decisions usually affect much more than the companys short-term economic situation. Therefore a thorough, long-term analysis (usually several years) is imperative.
inflow. The cycle starts when the company buys materials from suppliers and finishes when it receives cash from customers. The cash cycle becomes longer the more time the products stay in inventory (because while they are in inventory, products cant be translated into cash) or the more time it takes customers to pay. Concept 8.4: Planning investments
If there is information on these factors, how do we estimate the impact on profit of each of them? The process is simple, but must be done carefully. Starting at the original profit plan, and one-by-one each variable that makes up sales must be changed from planned to actual numbers. Each time one of these factors is adjusted, the profit plan is redone and the change in profits reflects that factor's impact on profits. Illustration 9.3 summarizes the step described above.
factors that reflect the way the company is organized, the complexity of its operations, products, customers, and distribution channels.
In ABC systems, cost drivers play the role that allocation bases did in traditional cost systems and trace the costs from activities (the equivalent of cost pools) to performance objects. However, the logic employed to choose cost drivers is very different from the one used for allocation bases. Cost drivers are the reason why the cost of performing an activity varies. A change in the level of a cost driver prompts a change in the amount of resources spent to perform an activity (the effect). For activities made up mainly of variable indirect costs, the cost drivers are often clear; they cause the variation in the level of activity. For example, energy is often a variable indirect cost that fluctuates with machine hours, its cost driver. Similarly, transportation is often a variable indirect cost as it varies with the number of shipments. ABC systems also recognize that there are more cost drivers than just volume (as traditional systems often assume).
The product or customer that yields more cash is preferred first, then the second and so forth. Concept 11.1: Constraints and scarce resources
Relevant cash flow analysis focuses on a particular decision and its short-term effects on cash. For pricing decisions, cash flow analysis typically equates to contribution margin analysis. When there are bottlenecks, contribution margin per scarce resource becomes the equivalent of cash flow analysis. For other operating decisions, relevant cash flows may include not only contribution margin but also relevant fixed costs. This analysis must be calculated for every decision, because each one is different. Also, though they are sometimes left out of the accounting system, opportunity costs can also be important. Concept 11.2: Contribution margin
A positive net present value means that the investment creates value, whereas a negative value means that the investment lowers it. From a financial standpoint, only investments with positive net present value should be approved. Concept 12.2: Cost of capital
yearly cash flows, the early years often have very poor cash flows, while later years are much better. Concept 12.4: What if analysis
The second approach is called step-down, and it considers the fact that support costs serve each other.
Finally, the reciprocal method is the most accurate, but also more complex and therefore seldom used in companies. It takes the services that support activities give each other into account.
Concept 13.3: Single and double rates for allocating support departments
When allocating support departments, it is important to separate fixed and variable costs (as it often is). Variable costs are relevant for short-term decision making, while fixed costs are not. Also fixed costs are vulnerable to the death spiral while variable costs are not. However, it is typical for companies to ascribe one rate that incorporates both fixed and variable costs. This is called single rate approach and may lead to problems. For example, in deciding whether to subcontract a support function such as HR, operating departments may compare the single rate (that includes variable and fixed costs) to the external alternative and decide to subcontract. This decision makes sense from the operating departments they get charged more internally than externally but it may not be good for the company as a whole. The outside option may be more costly than the variable costs in which case subcontracting is more expensive overall because the HRs fixed costs cannot be eliminated in the short term.
The dual rate approach leads to the estimation of two rates: one for variable costs and one for fixed. So if the outside alternative is more expensive than the variable costs rate, managers know that they should not subcontract. But if the outside alternative is cheaper than the variable plus the fixed cost rates, then the operating departments know that the support department is not as efficient as outside parties and needs to become more efficient. If it does not, in the long term it may be wise to shut it down and move to an outside supplier. Why? Because over a long enough period of time, both variable and fixed costs are relevant and can be eliminated. Concept 13.2: Allocation of support costs
lifecycle cost perspective. Target costing is used early on, and then Kaizen costing techniques are used once a product moves to the market. The concept of Kaizen costing (meaning constant improvements through small steps) also came from Japan. The basic idea is that devoting attention to cost reduction while a product is on the market can lead to significant cost advantages. Though generally 80% of costs are determined during the design phase, Kaizen costing addresses the remaining 20% and gathers ideas for cost reduction of future products.
The only difference is that the performance object is the customer or customer segments rather than the product. This approach, looking at the customer rather than the product, is most useful in understanding the behavior of marketing, sales, and post-sales costs. However, it can also affect production activities (as in the case of customers demanding unique features that require special setups). Chapter 14: Managing Customers and
addition of their profits, and so on. This graph gives a good picture of how profitability happens in a company. This graph frequently proves that companies have very heterogeneous client portfolios. Often, the distribution of revenues and profits fits the 80/20 rule, whereby the company makes 80% of its revenues or profit from 20% of its customers. Typically it also reveals that a profitable company is making money with one group of customers and losing money with another large group of customers. The shape of the graph resulting from this type of analysis often resembles the top of a whale coming out of the water so the pattern is called the whale curve.
Accumulated profit increases with the most profitable customers usually above the overall profit of the company until it reaches a maximum, and then profit decreases until the last customer (at which point accumulated profit is equal to the companys profits). Concept 14.1: Customer profitability
Customers are said to go through various stages in their relationship with companies: birth, growth, maturity, and exit. The birth stage is when the company invests to gain the customers business. Then, if it has done a good job, the customer will use more of its services thereby becoming more profitable until it reaches the mature stage, when the customer has most of its business in that particular market with the company. The last stage occurs when the customer decides to move its business to a competitor or stop carrying the product. Concept 14.2: Whale curve
First, people have a physical limit on how much information they can absorb. Second, moving specific information is expensive and slow. Third, empowering employees strengthens their commitment to the company. Committed people are a key ingredient in successful companies.
A final reason for decentralization is that the company does not depend on the abilities of a few people. Rather it can take advantage of the abilities of all the employees of the company. Decentralization is not as simple as shifting decision rights down the company. The new decision makers need adequate information. So improved financial and non-financial information is required, as well as access to it and appropriate motivation to understand how their decisions help the company and their own careers.
goals are then translated into much more specific objectives. Objectives are associated with targets, the level of performance that the manager is expected to attain. Targets are demanding to motivate managers to continuously improve. The second tool is to move the necessary information to the decision makers. If a manager is made responsible for quality, he needs to have timely, accurate, and relevant information on quality. The third tool is rewards. People like to be recognized when they have performed well and achieved a target. This reward can be monetary, though recognition is what people tend to value most. Complicating this is the fact that managers do not fully control whether a goal is met. It is therefore important to find the right balance between the scope of responsibility assigned to the manager and his scope of control. Concept 15.2: Responsibility centers