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The competitiveness of many firms is based on their ability to meet the customer demand on time and more constantly than the other competitors.

This concept is valid for both the manufacturing firms and the service ones.

To turn this strategy into reality and in a profitable way there are some steps to follow before it’s too late, before to face with the complaints from the customers and lose in the medium run a share of the market.

It’s better to make a sort of an internal strengths-weaknesses analysis before to choose a strategy and then realize not to be able to fulfil it.

The strategy must be well thought on the base of these internal factors after examining the external ones, the so called opportunities and threats.

When some constraints emerge the ways to be followed are two: either eliminating these constraints or throwing off the old strategy and addressing other success factors of the market, if any.

How can these issues be identified and then eliminated?

A deep knowledge of the internal processes is needed, in the meaning also of time spent on them and compared to the time resulting from the requests of the customers, of the extent to which every process is manned and its adequacy to what is determined from the market.

In other terms you must carry out a detailed analysis as deep as you can, starting from the potential share of the whole market you address on the base of your strategy.

Some concepts should be recalled before to show how to go along.

The Cycle Time is the time between the receipt of an order and the delivery of the output to the customers.

Inside that there is a  lapse devoted to the “execution” of the activities performed to manufacture the product or carry out the service (if service businesses), called processing time.

The ratio of Processing Time to the Cycle Time is the Typical Process Efficiency (TPE)

The terms used to identify these indicators change often from firm to firm. In particular the Cycle Time can be referred to as Lead Time.

In any case when the strategy of a firm is based on the timeliness and the speed of the delivery, the TPE target is 1 or in a realistic way one attempts to close that value as much as possible.

Nonetheless, a good ratio could be not enough to meet the requirements from the customers that need a fast delivery.

In other terms the processing time must be reduced.

The steps to help the managers pursue this objective are the identification of some constraints (here called bottlenecks) and the choice of the way to remove them.

 

 

You can proceed by using two methods: one simple and immediate, the other more detailed.

The former comes from the German management school and is called Takt Time.

There 4 steps to be followed:

1)Calculate the Available Capacity within the product/service line in a period of time. It’s advisable to consider the Practical one (in terms of labour hours or machine hours if capital-intensive business), that is the theoretical capacity less the holidays, the programmed maintenance, the set-up time.... and all the statutory and appropriate breaks to ensure conditions of normal efficiency.

2) Estimate the units of output demanded from the customers in the same period of time.

3) Calculate the ratio of the Available Capacity to the Output units, getting as a result the time (Takt time) per unit needed to meet at once, out of the inventory, the demand from the market without potential delay in the delivery to the customer.

4) Compare the processing time activity by activity per unit to the Takt Time.

 

If the company records a negative variance from the reference time, it means a failure to satisfy the requirements of the customer about speed and timeliness of the delivery/providing of the product/service .

It had be better keep at a slightly lower level.

 

An example will clarify the concept:

1) Monthly Available Capacity: 400 000 (labour time in seconds)

2) Units to be sold: 200 000

3) Takt time: ½ = 400 000 / 200 000 = 20”

 

Processing time by Activity per unit:

Activ 1: 20”

Activ 2: 18”

Actv 3: 28”

Actv 4: 20”

Total Processing Time: 86”

 

As you can see, the bottleneck is the Activity 3 where the time spent on the product/service is higher than Takt time (20”), meaning as a result an accumulation of work to be completed that translates into a delay in making all the output units needed to face with the customer demand at the requested time.

When this situation occurs you can resort to three solutions:

A) Increase the finished product inventory (if your company is a manufacturing one), incurring all of the respective inventory costs.

Moreover, if you are adopting a JIT policy with your suppliers, your efforts will be made partially vain by the increase in Work-in-process and fFnished product inventory

B) Try to drop the time of the bottleneck (activity 3) below the Takt time.

In this regard you can either redesign the typical process or the product/service being aware of not to change the value added to the customers.

C) Adding capacity to the bottlenecks.

As I wrote before, there is another more detailed way to identify the bottleneck that, in my opinion, is the most appropriate to make another solution more visible: the shift of the capacity from one activity to another if possible.

I say if possible, because of the features of the activity to be performed.

For instance, if the workforce needed should be specialized in the single activities, it’s clear how the shift of the excess capacity at a single activity to the bottle neck is not realistic.

 

Here is an example of the detailed way.

 

Alpha ltd is a company which produces three products: A, B, C.

The activities performed for every product are 4 (to simplify they are  in common to each of the three products).

 

Alpha ltd has estimated for the next month potential sales of 6,000 units broken down this way:

 

January 2019	Product A	Product B	Product C
Estimated Sales (Units)	3 100	1 900	1 000

 

In order to see if the firm will be able to meet the customer demand as timely as possible, you’ll have to take into account the processing time, activity by activity, for each product together with the available capacity (in this case labour hours).

January 2019

 

	Minutes for Product A Unit	Minutes for Product B Unit	Minutes for Product C Unit	Number of workers at 32 hrs a week	Monthly Available Capacity (1) = 128 hr x 60 x  employees	Monthly Capacity Needed by the Market (2) *	Variances (1-2)
Activ 1	35	25	30	30	230 400	186 000	44 400
Activ 2	31	24	28	20	153 600	169 700	-16 100
Activ 3	15	16	18	22	90 112	94 900	-  4 788
Activ 4	20	22	20	19	145 920	123 800	22 120
Total	101	87	96	91	620 032	574 400	45 632

 

 

* The Monthly Capacity Needed by the Market (2) by activity is calculated this way:

 

Activity 1 = (Min for Product A  Unit X Product A Estimated Sales) + (Min for Product B Unit X Product B Estimated  Sales) + (Min for Product C Unit X Product C Estimated Sales) = (35 x 3100 + 25 x 1900 + 30 x 1000) = 186 000

 

As you can see Alpha ltd has a total excess capacity by 45 632 minutes, but with reference to the single activities two out of four have a deficit.

In other terms those activities (3 and 4) are bottlenecks that require some adjustments to meet the customer demand.

Alpha could (amongst other solutions as I wrote above) shift the workforce from the activities with slack time to the bottlenecks if the people needed to perform them shouldn’t be very specialized.

You can also, on the base of these data and the Unit Price and Unit Variable Cost, determine the most profitable Product mix (topic dealt with at the article number 7 of this website).

I want to make notice that the latter profitable mix in case of constraints enables to face partially with the market demand by limiting the damages but in the long run the market segments sensitive to the critical success factor of the timeliness will “punish” the failure of the company to fulfil the orders on time.

In sum, the companies which choose to compete on the base of timeliness and the speed of the fulfilment of the sales order and, If manufacturing firms, at the same time  out of  inventory, should strictly analyze every aspect of the Cycle Time (Lead Time), that is the time spent between the receipt of an order and the delivery of the product/service.

First of all, that means looking into the processing time needed to bring forth the product/service and the available capacity on hand.

In so doing, you can take the corrective actions before it’s too late, before to fail the customer expectations.

The strategic side is in every decision, number, transaction concerning the mere management control activities.

Even about the most apparently operational reasoning there are some settings resulting from the  business strategy.

If we use the procedures in place forever, regardless of their consistency with the objectives of the company and its way to achieve them, we are not controllers but robots.

What I am saying is true even in the decision of the activity driver amount (labour hours, machine hours,....) over which you can spread the fixed industrial overhead costs when you are using a standard cost system and the full cost method to product-costing purposes.

The strategy of the business affects the amount chosen, for instance when it is a price leadership one and the managers make the price based on the cost of the products.

On the other side the strategy of differentiation can require new investments into better capacity-related resources and if you haven’t the right information on your capacity, you can invest money into new machinery and plants without knowing that you have already in place some available fixed assets that could be just “modernized” or just “manned” in the proper way.

I want to highlight some important points.

First, every aspect dealt with from now on concerns exclusively the strategic side and not any accounting “strategem” used by managers of manufacturing businesses in order to increase by some point the profit in the income statement of the fiscal period end.

In fact, in a standard cost accounting system, depending on how some variances of fixed overhead costs are disposed of at the end of the fiscal period, you can have the chance of increasing the income through the setting of one activity driver amount or another that impacts the value of the ending inventory.

This respect falls beyond the scope of this article.

Second, the following issues concern the fixed industrial overheads, meaning by that the expenses incurred to finance the typical activity of the firm.

We’ll call them for short fixed overheads.

The issues  being dealt with are valid also for service organizations.

 

How is the choice of a number able to facilitate the pursuing of one strategy rather than  another one?

 

First of all, It need to remind how the standard cost system works with regard to the fixed overheads:

- At the end of each reporting period a standard allocation rate, set at the budget time, is applied to the output of period.

Example:

1  SAR (Standard allocation rate): 25.

2  AQ (Actual activity driver amount: machine hours): 8000

3  Standard Fixed Overheads Applied to actual production: 1 x 2 = 200000

 

If you want to reason also in terms of output units, you’ll have to divide the AQ by the standard quantity of driver per unit (SQ).

In this case the number of machine hours per unit.

 

SQ: 5

AQu (output units): AQ/SQ = 8000/5 = 1600

Standard Fixed Overheads Applied to actual production: SAR X AQu  X SQ = 25 X 1600 X 5 = 200000

 

- The variances calculated with reference to the Actual values are recorded at the end of each reporting  period and cumulated till the end of the fiscal period (year) when they are disposed of according to some appropriate methods.

 

How do we set the standard allocation rate (SAR)?

There are five stages to be followed:

a) Define at the budget time the money to be spent next year for capacity-related costs not varying when  the output of the firm varies. Fixed industrial overheads.

b) Take an activity driver (measure) that enables to allocate the fixed overheads to the products.        Lacking a direct relationship with the output, a choice of a measure that represents the adherence of the fixed overheads as much as possible to the activity of the firm is needed. We can choose from different drivers (in a labour-intensive context the labour hours are the most suitable; in a capital-intensive one the machine hours are the best representative factors).

c) Choose a denominator volume, the amount of the activity driver over which we can spread the fixed overheads (number of labour hours, machine hours).

 

d) Calculate the Standard fixed overhead allocation rate, by dividing the value determined at point “a” by the amount of the point “c”.

 

Example:

 

a)      Budgeted fixed overheads:  $ 250,000

b)      Activity driver: machine hours

c)       Budgeted Denominator volume: 10000 machine hours

d)      SAR (standard allocation rate of fixed overheads): a/c = $ 25

 

I make you notice that when there are different product lines of which some with special fixed costs (for instance depreciation of machinery exclusively dedicated to a product line), some adjustment must be made in order not to burden other product lines with expenses that are not incurred for them.

 

This aspect is particularly important not only for product-costing purposes but as well when the department performances are assessed on the base of the full cost and it doesn’t sound fair to charge them also with costs incurred for other products of other "industrial" departments.

 

Which of the steps above described is crucial to our analysis?

 

The point c is the step that is the informative base of strategic decisions, either pricing decisions or investments ones or, yet, performance evaluation of operating departments.

 

In fact, the higher the denominator volume the lesser the SAR and the lesser the fixed overheads applied to the actual production.

 

Which are the criteria used to choose an appropriate base?

 

There are 4 criteria:

 

1. Theoretical capacity: the maximum number of machine hours (or other driver) available, 365 days a year, 24 hours a day.
2. Practical capacity: the maximum number of machine hours (or other driver) available net of holidays for people, programmed maintenance and other “breaks” needed to repair usual inefficiencies of the product line (business).
3. Normal capacity: the average forecasted driver volume for a time ranging from 3 to 5 years on the base of the demand for the output of the firm.
4. Budget capacity: the forecasted driver volume for the coming period on the base of the demand for the output of the firm.

 

In general the budget capacity is the lower (together with the normal one if in a decreasing demand period) of the four criteria and is not stable over the years, in a sense that is subject to the periodic fluctuations of the demand from the customers.

This aspect is negative when to fix the price on the base of the costs incurred since every year the managers are obliged to modify the prices, giving also the customers a feeling of uncertainty.

Always with reference to the pricing decisions, it is even more negative when it is lower than the practical capacity since it charges, through a higher SAR (standard allocation rate), the products with a greater share of fixed overheads including the costs of the unused capacity.

That will result in higher prices and a potential decrease in the demand, that in its turn will lower the output expectations for the coming period and, through a new higher SAR, will cause the manager to increase even more the prices (DEATH-SPIRAL effect).

 

As to the positive aspects of such a method we can consider the simplicity of it, particularly felt when in the company there isn’t a deep information system that allows the  needed calculations.

 

Dealing with the Death- Spiral Effect, if the company is adopting a price leadership strategy, you’ll see very easily how the choice of a budget capacity over which spreading the fixed overheads could be “deadly” in particular in periods of uncertain demand.

 

It is the most used by the managers regardless of their strategy and that is so impacting these days when the indirect costs have taken an even larger share of the total costs.

 

In my opinion the most useful and realistic capacity to be considered is the practical one for many reasons:

 

 1. It can be interpreted as the cost of unused capacity.

 2. The cost of unused capacity of point 1 is the base for investment decisions on capacity-related assets. In fact, showing an unused capacity and giving it a value, it works as an additional informative support to the managers who must decide whether to purchase other fixed assets or taking advantage of the existing and unused ones.

 3. It gives a steady base over the time on which to set the price in case of pricing on the costs and the company is not a price taker from the market, facilitating as a result the work of the managers and giving a feeling of certainty to the customers.

 4. It allocates to the standard cost of an output unit a lower share of fixed overheads, when the practical capacity is higher than the budget one, thereby reducing the base over which apply the price and regardless of the fluctuations of the demand. In other terms the customers will not charged with the inefficiencies of the firm and the death-spiral effect is avoided.

 5. It’s consistent with the accounting rules for external reporting set by both GAAP and IFRS.

 

 

 The point 5 takes a facet of external and fiscal importance so that I won’t focus on it further.

 

The crucial point to this analysis is, as you have understood, the unused capacity.

 

How is the cost of unused capacity assessed?

 

It is calculated through the Fixed Overhead Production Volume Variance, that is the difference between the budget Fixed Overhead amount and the Standard Fixed Overheads applied to the production.

 

The latter term is achieved through the SAR (Standard Allocation Rate).

 

A numerical example, showing the cases firstly of the use of the Budget capacity and secondly of the Practical one will clear the concept of unused capacity cost.

INPUT DATA

 

1. Practical Capacity: 12000 Machine hours

2. Budget Capacity: 10000 Machine hours

3. Actual Capacity: 8000 machine Hours

4. Actual Fixed Overhead Spending:  $ 280000

5. Budget Fixed Overhead Spending: $ 250000

6. AAR (Actual Allocation rate): 4/3 = 280000/8000 = $ 35 per unit

7. SAR practical (Standard Allocation rate with Pract capacity): 5/1 = 250000/12000 = $ 20.33 per unit

8. SAR budget (Standard Allocation rate with Budget capacity): 5/2 = 250000/10000 = $ 25 per unit

9. Standard  Fixed Overheads applied to actual production with Practical Capacity: 7 X 3 = 20.33 X 8000 = $ 166666

10. Standard  Fixed Overheads applied to actual production with Budget Capacity: 8 x 3 = 25 X 8000 = $ 200000

 

 

Exhibit 1 (Denominator volume: Budget Capacity)

 

Budget Fixed Overheads (5)	Standard Fixed Overheads applied to Actual Production (10)	Production Volume Variance (5 -10)
250 000	200 000	50 000

 

 

In this case The Production Volume Variance shows the extent to which the variance between Budget Output (10000) and Actual Output (8000) has caused a lower or higher absorption of the Fixed overheads in comparison to the forecast.

The absorption is higher when the Actual Output is greater than the Budget one, meaning that the share per unit of Fixed overhead cost is consequently lower with the following positive effect on the total unit cost.

In this case we also talk of Overapplied Fixed Overheads as a result of a different actual production.

 

The opposite happens when the Actual Output is smaller than the Budget One (the case of our example). Here we can also talk of Underapplied Fixed Overheads as a result of a different actual production.

 

 

Exhibit 2 (Denominator volume: Practical Capacity)

 

Budget Fixed Overheads (5)	Standard Fixed Overheads applied to Actual Production (9)	Production Volume Variance (5 -9)
250000	166666	83334

 

It’s clear how a different volume of activity driver causes a different Production Volume Variance that takes the same meaning as that of Budget capacity one about the “direction”, whether negative or positive, but under the Practical capacity hypothesis can be interpreted also as an indication of how much the unused capacity costs.

 

I say that can be interpreted because there are other more detailed ways to calculate the unused capacity cost that require some other information and bring about the breakdown of unused Capacity into Idle Capacity and Non-productive one.

 

The article here dealt with is intended, once more in the website, to show how even the choice of a number from a range of options has its own informative value, different from those of the remaining options.

Furthermore, the choice of this number is a result of the strategy of the business that has to adapt all of its information tools to its objectives and the “path” chosen to achieve them.

 

The topic of the procedure used to set the Fixed Overhead in a Standard cost system is not so simple  and if you want to ask for any more details you can get in touch with me by filling the contact form on this website.

The operating processes of a company working on projects in particular when carrying out over  a long time are for sure very different from ones of a company that manufactures products or provides services in a short time.

This difference shows up also in the work of the controller and the project manager that is affected in a typical way in the cost estimation process, in the assessment of the output done at a specific date and in the variance analysis.

Again, the main reason is the length of the time needed to accomplish the project whereas in a mass production company there is a cycle time that takes minutes, hours, days to give out a product/service to be delivered to a customer.

Many are the topics we could deal with about the project management control but we prefer focusing now on the most typical of all: the state of work.

When a project stars you’ll have to set some regular time points (called Time Now) over all the duration of the project when to assess both the technical and the financial state of the work done until that date.

If it is a multiyear project, the right periodicity might be a monthly one.

Of course that choice depends also on the kind of work.

On the financial side at the chosen date you must measure the costs incurred and evaluate the output done in order to see if the budget is being respected.

The hard point on issue is how to evaluate the output done to a specific  date.

First of all, you need to see how much of the work to be delivered at the end of the project has been gradually (to the various check dates) done.

This value is expressed in percent terms thereby applying the same percent to the estimated total revenues and achieving the money value of the output to the date.

How to calculate that percentage?

All of that said above needs to be made for every Work Package (WP).

 You know the WP is that part of the final project corresponding to some specific activities put in place by a given department or part of a department.

Those activities must have a person responsible for their accomplishment.

All of these pieces of information are drawn by the WBS (Work Breakdown Structure) and OBS (Organization Breakdown Structure).

The reasons why the WP is the object of this assessment are:

• It makes possible to find the person in charge of its execution.
• The activities falling into a WP have the same measurement unit (other WPs can have other kind of measurement unit and be either not measurable or intangible, thereby one has to resort to some appropriate methods).
• It makes possible the comparison to the estimated quantity,  having been object (the WP) of the budget stage.

 

Finding the percentage we are dealing with is hard in the case the output of the WPs is either intangible or not measurable.

As an example on the intangibility of the output we take the case of the approval by the Management Committee of a specific activity, consisting of the issue of an authorisation.

As an example of the non-measurability is when the engineering dpt works on a brand-new component of the final product and then it cannot take as a reference for the measurement of the advancement of the work the hours spent on it because one doesn’t know the exact amount.

You can do it but it’s unrealistic.

In any case the owner of the WP, the person responsible for it, together with the project manager must choose a criterion as objective as possible, that enables them to face with a potential opposition by the customer on the verification of the work done to the date.

Now these methods will be shown by taking as a focal point the main characteristic of the activities/products of the WPs.

The categories this way classified are:

 

a)      Activities whose duration is shorter than the lapse between two checks.

b)      Activities whose duration is short but longer than the lapse between two consecutive checks and the risk of financial and time overrun is small.

c)       Homogeneous activities and measurable products.

d)      Activities with significant intermediate events (milestones).

e)      Activities not subject to any kind of criterion.

f)       Irregular activities.

 

 

a) Activities whose duration is shorter than the lapse between two checks.

Some WPs consist of activities lasting for a very short period so that the knowledge of the real situation of the state of work isn’t of particular interest.

In this case the most suitable method is the ON/OFF criterion giving the value of zero to the percentage of work done at the very beginning of the activities of the WP ant the 100% percentage only at the end, when the activities are completed.

This method lacks the indications about the progressive completion of work done both in physical terms and in financial ones.

Factors that can be neglected only when the duration of the WP is very short.

Moreover, it could be made use of when the state of work to the date (we call the check date TIME NOW) isn’t tangible like in the example made above of the issue of an authorisation as the output of a WP, even if the duration of the activities is longer that the  lapse between two consecutive TIME NOWs.

In fact, even if the achievement of the authorisation is got through various operating steps (request, presentation of the respesctive documents and final letter), each of the intermediate steps when done doesn’t give any indication whether the authorisation will be achieved or not.

 

b) Activities whose duration is short but longer than the lapse between two consecutive checks and the risk of financial and time overrun is small

When that’s the case the 50% criterion could be the most suitable and easy way , consisting of giving the 50% percentage immediately at the start of the activities and the remaining 100% at their full execution.

In the reality of the businesses it is applied when the duration of the WP is up to three times as long as the lapse between two consecutive  checks .

Why is it applied?

It could make sense to apply the 50% criterion  when the benefits of the information about the state of work done are lower than its costs, since the collection of the data to measure the progression of the work is particularly hard and expensive.

This consideration is made also with reference to the risk of overrunning the financial budget threshold and time schedule, that has to be small.

Those reasons lead the project owner and/or project manager to get over the lack of indications about the real progressive accomplishment of work done both in physical terms and in financial ones.

In real terms in which cases does this criterion differ from the 0N/OFF one?.

Some WPs are characterized by a great initial inertia so that when the first step is done, one can consider the accomplishment of all the remaining activities as a formal issue.

The examples of the case are several and easy to be encountered in various business fields, so I refer the “effort” to spot some of them to anyone who may be concerned.

 

c) Homogeneous and measurable products

When the WPs consist of homogeneous activities to be performed that give outputs measurable by the same measurement unit, then, the most suitable method to determine the percentage of the progression of the work done is the FINISHED UNITS one.

It consists of calculating the units worked (worked hours, physical units) and finished accumulated to the TIME NOW and dividing them to the estimated total of the same units at the end of the WP.

The percentage you find is then applied to the total of the value of the full WP and, as a result, you  have got the value of the state of work.

The precision of this criterion is certainly very high and it allows to have a precise view of the progression of the project both in a technical sense and in a financial one, by highlighting delays and financial variances in comparison to the original budget.

The way you calculate the financial variances will be one of the future subjects of www.thestrategiccontroller.com

It is very useful for long-term projects where the check on the advancement is crucial to put in place corrections actions when they are possible before it’s too late.

Of course, a suitable organization is needed to get this criterion applied.

What do I mean by that?

In order to have the correct data in a precise and timely way, some features must be there.

First of all, appropriate forms to be filled about the execution of the work must be distributed to the operating personnel.

A culture of real collaboration amongst the departments has to be spread, minimizing, as a result, the risk of the operating personnel underestimating the filling of those forms built by the administration dpt. people.

This phenomenon is rather common in most of the companies working on multiyear projects.

Another aspect to deal with is the collection in a timely way of these forms duly filled.

In facts, when it is hard to set at each point of the works (examples recurring in great structure construction projects) some collection points, the same collection and following transmission of the data could be delayed and as a result the precision of them at the TIME NOWs could be compromised.

Last but not the least, the setting of what is needed to make this criterion perform mustn’t be too expensive.

In other terms a cost-benefit analysis is always necessary.

 

 

Here follow a simple example showing how this method works.

 

Input Data:

Work Package AB1 of the Project Alfa

Units to be delivered: 13

Activities of the WP: 5

 

Exhibit 1 (State of the Work according to the Finished Units Method)

	Units delivered	Percentage to the total	STATE OF THE WORK (accumulated % after each activity)
Activity 1	3	23%	23%
Activity 2	5	38,5%	61,5%
Activity 3	2	15,5%	77%
Activity 4	3	23%	100%
Total	13	100%

 

 

d) Activities with significant intermediate events (milestones)

Especially in long-term projects we can find over the period of the works some events representative  of a certain degree of the achievement of the final goal/output.

Of course, these events must be verifiable.

When these features are present, the most suitable method is the Predetermined Weighted Importance (or Milestones) one.

What does it mean?

Each of the activities of the WP must be examined in depth and be attributed at its completion of a percentage as a measure of its weight with regards to the total weight of the WP (equal to 100).

The final execution of each activity, as written above, is represented by the occurring of a specified event.

Who is the person in charge of firstly (in the planning phase)spotlighting and then, in the execution phase, certifying  these events?

The most recommended is the man who has a deep technical knowledge of the subject activities, that is the so-called owner of the WP, responsible for their execution.

The steps suggested to give a specified percentage to the activities a WP is broke down into are the following:

1. Spotting all the activities of the WP.
2. Choosing which of them are the most important/hard to be accomplished.
3. Giving the activities of the point 2 a value between 1 and 100.
4. Distributing the remaining points out of 100 to the other activities.
5. Examining again the score of each activity compared to those given to the other activities (to achieve scores making sense) and making, if it’s the case, some corrections
6. The percentage of each activities is easily determined.

 

Exhibit 2 (State of the work according the Predetermined Weighted importance/Milestones)

	Weight	STATE OF THE WORK (accumulated % after each activity)
Activity 1	15	15
Activity 2	35	50
Activity 3	30	80
Activity 4	20	100
Total	100

 

The procedure shown above can be seen as a  complex one, and for this reason it takes long time, but you have to consider that it’s subjective, related to the knowledge and competencies of one person and, as a result, is debatable.

To reduce this risk, then, it’s better to spend some more time.

 

e) Activities not subject to any kind of criterion

Sometimes the “usual” criterion made use of cannot be applied because either the technical features are not corresponding to those requested by any of the methods known or the application of the same methods is more expensive than advantageous.

That’s why one refers to the “Estimated percentage criterion”.

The assessment from an external Verifier, not the person in charge of the execution of the activities, appears to be the only solution to determine the percentage of the work gradually accomplished.

Like the criterion explained at the previous point, this is subjective, even at a higher degree.

To reduce the risks of the opposition and disputes with someone, customer first of all, the technical skills together with the experience and the honesty of the verifier are needed to be known

There are two methods the verifier can apply to assess the state of the work to the date:

1. The direct method.
2. The indirect method.

 

In the first case, the verifier assesses the quantity of the work done to the Time Now in proportion to the foreseen final output in order to give it a percentage.

In the second case, he subtracts from the foreseen final output the quantity left to be completed.

If you want to judge both the methods, the indirect method appears to be more pessimistic because it tends to overvalue the remaining work and for the same reason it is more incisive in motivating the people to finish all the activities.

On the other side, there is the risk that the value this way achieved by the state of the work to the date is lower than the real one.

Just in the comments on the indirect method you can see even more the limitations of the individual assessment  typical of the Estimated percentage criterion.

I remind the application of it must be the ultimate solution.

 

f) Irregular activities

Often you can find over the whole path of the WP the same activities but with a diverse intensity in terms of difficulty and, as a result, of duration and quantity of resources (worked hours, raw material quantity) employed.

We take the case of great structure engineering projects and construction ones.

For instance, the construction projects could have different points where to carry out the same activities.

It’s natural that these points have diverse characteristics (morphological, geological) from one another requiring more or less time, more or less resource consumption with reference to the same work activities.

It’s clear the “finished units” criterion cannot be applied, because every output unit has a different weight and incurred cost.

Then the criterion fitting it better than all the others is the “output proportional to the input used” method.

It consists of dividing the resources consumed till the Time Now to the total of the same ones foreseen to accomplish the WP. This percentage is applied to the ending estimated output of the WP, achieving as a result the state of the work to the date.

On the financial side, the application of the subject criterion is cheap enough because the collection of the data reveals itself easy and in some cases they  can be gathered from consolidated and known processes.

This method allows to have a precise view of the work over all the time horizon of the project/WP but there must recur some conditions.

In fact, if there was a change in the productivity of the inputs, because of a variety of causes,  the state of the work assessment could be distorted.

Secondly, for outdoor activities, atmospheric agents need to be in line with the expectations, otherwise they could vary too much the quantity of resources and time spent in comparison to what had been taken into consideration.

Another criterion used in the case of irregular activities is the Cost-to-Cost one.

It considers the resources consumed to the Time Now on the financial side.

You need to divide the costs incurred to the date for performing all the activities to the total costs estimated at their accomplishment.

It’s the most easy to be applied, but I remind that in the calculation of the projects costs you have to consider the costs for the goods ordered but not yet recorded.

I will more clear.

The lapse between the issue of an order for the goods needed for the actvities to be executed and the recording in the accounting books of the respective costs can be great.

If you take into account the costs recorded in the accounting till the Time Now, you won’t have an exact “photo” of your expenses and the state of the work assessment won’t reflect the reality.

Essential condition for the consideration of the goods ordered is their exclusive purchase for the WP, that is the goods ordered to be stored and used in case of necessity must be excluded.

Then, the business needs to set an extra-accountancy system in order to consider in a timely  a precise manner all the information related to the project.

 

The choice of a costing system may look as an independent variable for any of firm called to make it, so we assist to many managers in choosing and implementing it with no consideration of the kind of information needs, their timeliness, the strategy of the firm itself and the kind of industry.

The costing for products, services, projects as well as customers, distribution channels, is crucial  for any kind of industry.

It’s important for pricing needs, for make-or-buy analysis, for profitability analysis, for financial statement drawing up.

Make the case of a company using the Target Costing which takes the price from the market and needs to calculate the cost of its products to see if the desired profit is achieved or will be achieved.

Without an accurate costing system every kind of measurement  will be wrong, will give the wrong information with the following wrong corrective actions to be undertaken.

The controller, as a result of these considerations, needs to take into consideration three criteria:

1. The process of the cost accumulation.
2. The overhead allocation method.
3. The cost measurement.

 

As you can understand the management accountant/controller that takes as given any kind of costing system and adapts the “firm” to it without reasoning on each of the listed criteria, is not doing a good work.

 

Now, we’ll examine the existing costing systems for any of the criteria in a simple and clear way, just to help anyone concerned make that choice.

 

1. The process of the cost accumulation

 

There are three methods of costing according to the criterion of the process of the cost accumulation:

 

a) Job Costing.

b) Process Costing.

c) Operation Costing.

 

 

a) Job Costing

 

When the costs recorded, direct material costs and direct labour ones and overheads, are traced to specific jobs, we are in the presence of Job Costing.

Of course these costs must be easily identifiable and their traceability has to be as objective as possible.

 

In particular the overheads are traced to a particular job on the basis of a chosen criterion that reflects  as best as you can  the consumption of the respective resources (indirect materials, indirect labour, utilities, assets) by the job.

 

What follows is an example of the calculation and traceability of the overheads to a specific job.

 

 

Company A manufactures high-end pens and its main cost driver is the amount of labour hours, that is the firm is a labour-intensive one.

 

Exhibit 1 (Monthly Overheads)

 

Products	Working hours (1)	Total Overheads incurred $ (2)	Overhead ratio  (3=2/1)	Overheads charged to products (3 x 1)
Pen A	1400			43077
Pen B	1200			36023
Total	2600	80000	30.77	80000

 

The objects of the costing process may be also customers, projects, distribution channels and any else thing that absorbs the resources in a specific and identifiable way.

 

The traceability directly to the objects is explained also by the organization structure of the firm as well as by the strategy.

With reference to the firs point we think of those companies with very few departments  and/or when each of these are dedicated to one of the products/services/projects done.

It’s clear there isn’t a strict rule to be followed , this statement springs up from the observation of the business reality.

 

Now we’ll look at the role played by the strategy.

 

Also in this aspect the strategy cannot be disregarded. Every choice/decision of business life must be affected by the way the company tries to achieves its objectives.

 

The company carrying out a differentiation strategy is likely, when its cost are identifiable,  to put on a job costing system because it isn’t particularly interested in the search of an efficiency objective of its departments.

It charges its costs to the customers when makes the prices since the customers is less sensitive to it than they are in other industries.

Nonetheless, the search of it, although at a lowest degree compared to the low-cost companies, is always advisable.

If you think of the businesses working on projects (when the personalization is predominant) the job costing is the most natural choice.

An exception to that is when the price of the project is set as a lump sum, that is it is set from the beginning (except for  the work variations requested from the customer) and the way for the company to make the highest profit is to reduce its cost as much as possible and the search of the efficiency of its departments is  very important.

 

 

b) Process costing

 

The opposite of Job costing is the Process costing applied by companies producing similar and homogeneous products in a high volume.

Examples of the firms using this method are those operating in industries such as mining, paper, some kind of electronics, chemicals.

 

How does Process costing work?

 

All kinds of cost are accumulated by each department and then the total is divided by the equivalent units of the production quantity.

The costs of all the departments are then totalized to achieve the total manufacturing cost.

 

The process costing is not typical only of the manufacturing companies but it can be used by service ones providing repetitive and homogeneous output.

 

The strategy of low cost and low price is the most appropriate because of the high volume of the products and it’s pursued  often by using high-capacity machines and technologies, identifying and eliminating bottlenecks (points in the process where too much work is accumulated , slowing down as a result the manufacturing cycle).

 

Nonetheless the differentiation strategy is also pursued in this costing method, depending on the specific competitive environment, through the improvement of the quality of the process.

 

An important issue when you adopt the process costing is the way you calculate the equivalent units.

It isn’t the goal of this article and that’s why I’ll limit myself  to the mere concept.

 

At the end of a reporting period you’ll have some finished products and some partially finished ones, that is Work in process.

In the process costing the objective is to calculate the cost of the processes performed during a period, the opposite of the job costing where the focus is on the product.

That difference affects the  calculation of the Work in process, not being a clear cost object.

So you have to resort to the equivalent units (department by department), that is the number of units that could have been finished  by taking into account the quantity of work performed in the period on both complete and partially finished units.

 

A particular process costing system concerns the joint products, that is those ones derived from a common raw materials undergoing the same processes and that don’t have any difference  until the split-off point where the semi-manufactured outputs are separated to follow specific processes, each of them with typical features, that differentiate them.

 

 

c) Operation costing

 

A mix of the two preceding methods is the operation costing consisting of the job costing system for the material costs that are charged directly to the cost objects and of  the process costing system on the basis of which the other cost categories are assigned to the departments and allocated to the cost objects according to some criterion.

 

Operation costing is used when the firms manufacture/provide different products/services starting from a common base of activities.

 

Examples of industries using this method  are electronic equipment, furniture and textiles.

 

The firms addressing to a large range of market segments use this method and they are able both to pursue the innovation strategy through the high quality materials and containing the costs of the operating activities by the enhancement of the processes in each department.

 

 

2. The overhead allocation method

 

The overheads are costs not directly traceable to the products or other cost objects without using a a chosen allocation base.

That means there isn’t a clear relationship between the amounts of output and the consumption of the resources highlighted as “overheads” and that’s why you must resort to a choice of a driver that expresses as best as you can the amount of overheads absorbed by  a product/service/project/customer/department.

 

The methods used are:

 

a)      Volume-based

b)      Activity-based

 

a) The volume-based approach

 

It  uses the units sold/manufactured by product to allocate the overheads, that is these expenses are assigned to each product in proportion to the respective output.

Other bases used by this approach are the labour hours and/or machine hours (depending on the kind of predominant resource used), that allocate the overheads in proportion of the driver amount recorded per each cost object.

As to the product/service this allocation is done either directly to the product/service (job costing) or by passing first through the internal departments (process costing).

 

All the volume-based approaches assume that every unit of the chosen driver absorbs the same amount of overheads and that’s the core of the allocation on the basis of the respective consumption of the same driver.

 

b) The activity-based approach

 

It starts from the assumption that the activities and their amount aren’t always the same for each product and, since the activities are the causes of the consumption of the resources and their costs, the costs not traceable directly to each product/cost object must be allocated on the basis of a driver (activity by activity) that expresses as best as you can that different absorption.

Nonetheless, in some cases some of the drivers are volume-based for those activities whose “quantity” is linked to the output produced.

 

This approach leads to a more accurate costing that is of great advantage to the decision-making process in the long term when also the fixed costs must be taken into consideration.

 

 3.  Cost measurement

 

According to this criterion we have  three kinds of costing systems that are put in place by the companies on the basis of their need of information.

 

These needs are the timeliness of the information, the purposes of product costing, cost control and the planning decisions

 

These three kinds follow:

 

a)      Actual Costing

b)      Normal Costing

c)       Standard Costing

 

a) Actual Costing

 

In this case all the costs (direct labour, direct materials, overheads) are recorded after their incurring, according to the actual consumption and the actual “price”.

This method is used particularly when the decision-making need as well as the business planning one have to be fulfilled on the basis of the real costs.

 

b) Normal Costing

 

The direct labour and direct materials are recorded when they are incurred according to the actual consumption and the actual price, while the overheads are recorded on the basis of an estimated Overhead allocation rate multiplied by the actual driver amount (units manufactured/labour hours/machine hours), achieving as a result the Applied Overheads.

 

The predetermined Overhead rate is calculated by dividing the estimated Overheads for a period by the estimated amount of the driver for the same period.

 

This approach is used when the availability of the information for every decision in a timely manner is needed.

 

Furthermore, this method avoids the fluctuations over the time of the full costs of the products/ services following the changes in the monthly output  and, as a result, the changes in the overhead rate used in the actual costing.

 

Of course the difference between the Applied Overheads and the Actual ones (according the actual rate) must be balanced at the end of the reporting period.

 

c) Standard Costing

 

All the cost categories are recorded when they are incurred according to their standard “price” and standard quantity and put in comparison to their actual “price” and actual quantity.

 

This approach determines the calculation of the variances in their distinctions (price variance, usage/efficiency variance) very useful for cost control purposes.

 

The standard system requires, of course, the real chance of its application in particular when the setting of the standard “price” and “quantity” of the resources is possible (for instance non-customized productions) and it is not expensive.

 

These costing systems shown above can be combined according the needs of business information and its strategy.

 

You could have an Operation/Activity-based/Standard method as well as a Process/Volume-base/normal costing one-

 

This decision is on the top management of the company that should follows the advice from the controller/management accountant whose role is always more important to put in place all the tools to make the firm successful .

I have been hearing for some time a lot of professionals arguing on socials about the validity of the budget, in a sense that, according to many of them, the budget could be, in a near future, put aside.

What is the reason for that?

The failure of reaching the objectives set into the budget: Net income, Operating profit, Sales revenues, Department financial objectives and so on.

My doubts are the following:

Are the companies involved applying the right actions to execute their strategy and achieve the related goals?

Are the managers involved drawing up the budget in an appropriate way?

As to the first question I cannot tell anything from outside the single companies, lacking all the needed information.

Instead, as to the second doubt I feel like making some considerations, as a result of my experience and as far as I have learnt from debates, readings, studies about this issue.

We all know that the budget is like a will statement whereby the top management states where the business wants to be within the end of the next period, in terms of and according to the objectives set by the multi-year planning.

In which context do we operate?

For many years, except for some specific niche fields, the uncertainty has been reigning in a sense that it’s getting more and more hard to predict with a reasonable degree of certainty what will happen next year.

That’s because of many factors such the increased competition, the change of the traditional markets, regulatory factors and a galloping innovation.

As a result the traditional budget as a simple will statement must be reviewed.

The top management must take into consideration the uncertainty and the risks involved in the market the companies operate, without making the orientation and motivation functions of the budget fall.

How can they do that?

In managing the risks involved in some operating decisions as well as in the evaluation of projects there are techniques known to many professionals.

Only for making what I am writing about clear I now recall the models used to deal with the uncertainty, all of them identified as Sensitivity Analysis methods and then I’ll show my view about their application to the budget decision-making process.

1) What-If analysis

It’s the simplest method and consists of verifying the changes in an dependent variable following the changes in an independent one.

The example that comes up to my mind is the various levels of the commercial profit as a a result of the changes in the qunatity of units sold.

Exhibit 1

	Situation A (1000 units sold)	Situation B (1200 units sold)
Revenues (price  $ 20,00)	20,000	24000
Commission ( 10%)	2,000	2,400
Commercial Contr Margin	18,000	21,600
Structure Commercial Costs	7,000	7,000
Commercial Profit	11,000	14,600

 

2) Scenario Analysis

A more complex analysis is, without any doubt, the scenario analysis since it requires the work of a cross-functional team (marketing people, planning dpt people, procurement dpt ones,...) that draws up more scenarios, each of them associated with a particular state of the demand or other factor for the products/services/projects of the firm.

Generally, the scenarios are three: the worst one, the normal one, the best one.

For every scenario the “items” taken into consideration get a value different from the one associated with another scenario, except for the fixed costs (when the independent variable overcomes a given threshold, as well the fixed costs will vary).

As a result of these differences the expected final value for each scenario is different.

What have you noticed so far?

The probability of each case/scenario occurring has been neglected.

We have to start from the consideration that often the events taken into account don't have the same probability of occurring and in order to make a good analysis we cannot help but make a probability distribution.

The cross-functional team is entrusted with determining the percentage of the potential occurrence of each state.

This way of working is typical of the Capital Budgeting  (investment analysis) as well as of Project Management in order to assess the impact of the risk and the uncertainty in the decision making.

Here below an example is shown.

The variable of interest is the Project (or Contribution Margin: different concept from the one used in a mass production firm) Profit for Project management purposes while it is the Net Present Value for investment analysis

Exhibit 2

	Worst Scenario (30 %)	Normal Scenario (45%)	Best Scenario 25%)
Project Profit/NPV	2,000,000	3,200,000	4,200,000

The Expected Monetary Value (EMV) must be calculated for the variable concerned:

EMV = (30% X 2,000,000)+(45% x 3,200,000)+(25% x 4,200,000) = 3,090,000

Now the decision makers can decide whether the potential earnings from the Project/Investment are acceptable to their strategy.

 A statistical method used to see all the possible outcomes of your decisions and assess the impact of the risk, allowing for better decision making under uncertainty is the Monte Carlo Simulation that provides the decision-maker with a range of possible outcomes and the probabilities they will occur.

Of course, like in the previous example it’s advisable to calculate also the Expect Money Value to better assess the potentiality of the Project/Investment/Decision.

This article and this website aren’t the place to examine in depth any statistical method, therefore if you want to learn even more about the Monte Carlo Simulation, I refer you to the rich existing sources.

When you are facing with alternative projects/investment decisions characterized by different features and a different cost structure (I mean a diverse proportion of variable costs and fixed ones), you can resort to a quantitative approach that takes  into account the EMVs and assess the different impact of the risk.

Why Do I write about different cost structure?

If you are aware of the concept of Operating Leverage, you’ll know the business/project/investment alternative has a different sensitivity to the fluctuations in the respective demand.

For instance, comparing two firms with the same profit at the same level of units sold, we’ll see that  the firm with a predominance of fixed costs will gain more than the one with many variable costs when the demand increases, but at the same time it will lose more when the demand decreases.

That quantitative approach is called the Decision Tree and it is a diagram where the alternative decisions are highlighted together with the respective events (results) originated in correspondence to each scenario.

 

                                                                                                                         0,30                     4   (2,000,000)

                                                                    2 Project (3,090,000)                    0,45                     5   (3,200,000)

                                                                                                                         0,25                     6   (4,200,000)                 

 

1      (New road construction)

 

                                                                                                                           0,30                    7  (1,300,000)

                                                                    3 Project (2,955,000)                      0,45                    8   (3,200,000)

                                                                                                                           0,25                    9   (4,500,000)

 

In this example we have assessed two projects (2 and 3) to build a a new road.

Project 2 has a predominance of variable costs differently from 3 that has a predominance of fixed ones.

We calculate the EMV for each project as an average weighted with every scenario probability.

The probability (0,30-0,45-0,25) for each scenario are shown near each result (4,5,6 for Project 2 and 7,8,9 for Project 3)

The project 2 is the most profitable (EMV=3,090,000 against EMV=2,955,000).

Of course there are other methods to estimate the potential profitability of projects taking into accounts the risks and the uncertainty but we are considering the most recurring ones and making a sense in the context of what we are writing about.

 

The uncertainty in the budget process

 

After scrolling down some of the methods used to deal with the risks and uncertainty for specific cases, now we’ll look at how this issue can be adapted to the most important document of yearly business management.

Many people look at the budget as a will statement about where the firm will be at the end of the next period, but the uncertainty about the future is greater than ever due to continuous innovation, the entrance of more and more competitors, macroeconomic situation, the development of new markets.

Furthermore the functions of the budget are manifold, first of all in a strategic sense:

1) Orientation for the achievement of the business goals by respecting the guidelines of the multiyear planning.

2) Motivation for the department managers.

3) Benchmark for the performance evaluation and the manager compensation system.

If we want to deepen the issue, we cannot help but considering that the department budgets are often the result also of a sort of negotiation between top management and dpt managers, in particular about the overheads.

You’ll know, therefore, how to set a rigid procedure is unrealistic.

In any case e good top manager, when setting the main guidelines, in particular of the Master Budget (Aggregated Budgets), must consider the uncertainty of the scenarios his firm is going to face with next year.

How to do it?

Any budget procedure has a main “document” on the basis of which all the other dpt managers begin “reasoning”.

In a mass production business that document is the Sales dept Budget, while in a job production business it is the Engineering dpt Budget where the project hours are the drivers of the other economic data.

The method most suitable for taking into account the impact of the risks and the uncertainty is the development of the potential future scenarios about the determinant drivers, in the first case the units sold and the project hours in the second case.

In other terms, you have to elaborate the potential market acceptance of the output of the business according to the scenarios that can come up next year.

Therefore, out of the methods we have seen, the scenario analysis is the most appropriate to the Budget procedure development and it requires, more than ever, the work of a cross-functional team, first of all the joint work of the Strategic planning dpt and the Marketing dpt, entrusted with the task to make on a realistic basis the estimation of the future economic situation affecting the business, starting form some input data such as the kind of products/service/projects, their prices and  resulting in the number and value of the estimated sales and share market.

After determining these scenarios, the likely percentage of the respective occurrence must be calculated.

Take the case of Exhibit 2.

	Worst Scenario (30 %)	Normal Scenario (45%)	Best Scenario /25%)
Project Operating Profit/NPV	2,000,000	3,200,000	4,200,000
Units sold	12000	18000	24000
Market Share	6%	8%	10%

 

If the Managing Director would limit oneself to a mere statistical reasoning, the Normal Scenario (and the respective number and kinds of products/services/projects involved), should be the one of his choice, without any doubt.

Nonetheless we have seen the budget cannot be confined to a percentage calculation because of its nature and procedure and individuals involved.

Then, how can you go along?

The following steps aren’t intended to be a set of instructions but just some general guidelines.

That is because every firm has its own structure and its own external environment (competitors, suppliers, customers, technology).

All of these factors lead me to show a simplified and very terse procedure in order to “make the concept clear”  in  the best possible way:

1) The  Managing Director in my opinion should be aware, as a starting point, of the break even quantity.

As a matter of fact no one should set an objective under the  threshold that enables to make profit.

Are we sure that many managers have this point calculated before to state goals of any sort?

I hope so.

Of course, that amount isn’t conclusive, because over the process some value estimations (fixed costs in primis) are subject to variations.

2) In consideration of the strategy of the business, of its phase in its “life” and of its financial standing (remember that every goal of revenues requires prior outlays  such as investments in both structure assets and in net working capital)  a scenario (of course over the break-even point) must be chosen.

Make the case of a consolidated business, well-known to the market and with a solid financial standing, with a low-cost strategy (its objective is to distribute the fixed costs over an increasing level of output in order to make the unit cost lower and as a result to apply lower prices, achieving the increase is market share and revenues).

The choice should be between the Normal Scenario and the Optimistic one, with a corresponding value of ROI, market share and other external and internal goals (the Balance Scorecard should be preferred) when possible.

The risk adversion of the top manager will tell us how far the level of predicted and wanted sales is from the Normal point.

3) The Controllers coordinate and set the several documents (operating budgets and aggregated ones) as a result of the calculation techniques, their competencies and skills, the information received and, in case of “disputes” between top management and dpt managers (about the feasibility of the goals, the fairness of them if these are set also as a benchmark for the performance evaluation and compensation determination), of their intermediation role.

4) At the end of these long steps and if all the hurdles have been overcome (last but not least the financial sustainability), the controller submits the “Budget” to the judgement of top management that approves.

5) If the budget doesn't overcome its hurdles and/or it doesn't reach its objectives, the procedure will start again on the basis of new goals, modulated downwards.

 

Again, this list of steps are only indicative because we are aware of the complexity of the subject but it is intended to support the theory of the validity of the budget if the risks are considered in its elaboration.

The reality where the businesses operate is more dynamic than ever and the uncertainty reigns.

The assertion about the obsolescence of the main programming document of the firms often doesn't take into the right account the incompleteness of the events set as a basis for the drawing up of the whole budget process.

Only when we are sure that also the uncertainty is considered together, of course, with the use of most up-to-date cost management techniques, and the actual is more and more far from the budget, only then, we can seriously argue about the uselessness of the budget (both static one and rolling one).