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 The most part of financial managers, management accountants, CFOs use the same criteria to make decisions both in an operating sense and in a strategic one, both for profitabilty analysis and in investments decisions even if their company suffer from some sort of constraints.

Nothing more wrong.

You must take into account the same criteria (contribution margin, net present value and others..) but referred to the constraint per unit. The alternative with the highest value is the best.

To be more adherent to the reality of a business I will make ONE example of decisions in the presence of constraints, although the number of such cases is greater than you can guess and often there is the simultaneosly presence of two or more constraints (who wants to know further details can contact me).

Operating case:

A manufacturing company has a capacity of 480 machine hours per month and makes 3 products, whose profitability in terms of contibution margin is now shown:

                                                   A                  B                C

Price                                       150               120            180

Unit variable Cost                     80                 75              95

Unit Contribution Margin           70                 45              85

The manufacturing dpt has received orders for 2,000 units of A, 2,500 of B, 1,800 of C, but the machine hours needed for accepting all the order exceed the capacity of the plant.

Note that for simplicity we guess that the same machines are used for all of three products (one must change some of the settings)

                                                            A                   B                C          total             

Unit Cycle Time  (hours)                   0,07             0,08          0,12      

Order Units                                     2000             2500          1800      6300

Total Cycle time                               140               200            216         566

Available capacity (practical capacity)                                                    480 

As we see there is a "deficit" of 86 Machine Hours.

HOW DO WE DECIDE?

As far as we know by looking the Contribution Margin Report, it seems the product to be preferred is C with the Unit Contribution Margin of 85.

That would be the case in normal conditions but in presence of a constraint we have to see how much the reference unit of the constraint (in our example the machin hour) gives in terms of contribution margin for each product.

That's why we make these calculations:

                                                     A                  B                C

Unit Contribution Margin              70                45              85

Unit Cycle Time (UCT)                0,07              0,08           0,12

€ per machin hour (A/B)            1000             562,5         708

Now the preference is A, C, B.

That means that, to understand how to accept the orders, we proceed this way:

A  = (Units  to be manufactured)2,000 x  (UCT)0,07 =  140 machin hours to be operated

C = (Units to be manufacured)1,800 x (UCT)0,12 =    216 machin hours to be operated

A + C =                                                     356  intemediate mach. hours to be operated

Cycle time remaining (CTR) = (Practical Capacity) 480 - (Intemediate mach. hours to be operated: A + C) 356 = 124

Units of B to be manufactured = CTR/(UCT of C) = 124/0,08 = 1550.

FINAL MANUFACTURING ORDER

A             B            C 

2000    1550     1800

Whether you are adopting a price strategy or a differentiation one, you need to know whether it is the right choice. 

That means  you have to know whether the costs, you are incurring, are going towards the customer's requirements. 

If your management control system isn't set on an ACTIVITY APPROACH (ABC, ABM) or you haven't ever carried out the target cost method, the task to be performed isn't easy. 

It isn't easy but not prohibitive. 

In the following lines I'll make a simple but realistic example of how to act in the business reality. 

1. Know, through interviews and other ways, what the customer criteria are to buy a product and the respective ranking by using a 1 - 100 value scale: 

We identify the criteria with the letters A, B,C (these can vary according to the item which we are performing the survey about: price, dimension, safet, durability,......) 

                                       Customer criteria and ranking  

                                  Importance                      Relative importance 

                              (from 1 to 100)                  (Importance to total)       

A                                    90                                          45% 

B                                    60                                          30% 

C                                    50                                          25% 

TOTAL                         200                                        100% 

2. Identify the components of the product together with their costs and respective weight: 

We indicate the components with the numbers. 

Components             Costs                Percent Cost Weight              

1                                     € 50                       50% 

2                                     € 30                       30% 

3                                     € 20                       20% 

Total                            € 100                      100% 

3. How each component meets the customer criteria. 

That is, put on a cross-functional team with the goal to give each component a percentage in satisfying each criteria:    

                                                            Customer criteria 

Components                      A                        B                     C   

1                                         30%                    20%               40% 

2                                         20%                    40%               30% 

3                                         50%                    40%               30% 

TOTAL                              100%                  100%            100% 

4. Importance index of each component, by multiplying the relative importance of step 1 of each criterion by each component's percentage weight and summing the amounts so calculated. 

Importance index for 1:       (45% x 30%) + (30% x 20%) + (25% x 40%) = 29,50% 

Importance index for 2:       (45% x 20%) + (30% x 40%) + (25% x 30%) =  28,50% 

Importance index for 3:      (45% x 50%) + (30% x 40%) + (25% x 30%) =  42,00%   

5. The final step requires to compare the Importance index of each component with the a percentage cost weight (actual or estimated one, depending on you are on an audit or planning basis). 

Components                     Importance Index        Percent cost weight           Deviation 

                                                                                                                                     (PCW - II) 

1                                                29,50%                               50%                                    20,50% 

2                                                28,50%                               30%                                      1,50% 

3                                                42,00%                               20%                                   -22,00% 

You are spending more than requested on 1, less on 3, and you are in line about 2. 

In my opinion the activity approach enables to be more precise, thanks to a more detailed imputation of the overheads, but the way shown here is a good way for the businesses with the volume-based costing systems. 

Is there a number, a score that summarizes the success of the company "on the field"?

Often, any of financial and non-financial indicators takes into account only one of the aspects of the business management and that isn't a coincidence.

As a matter of fact many goals are achieved to the disadvantage of the others.

You need to have a global performance indicator about the business management within its reference sector.

My opinion is that the best financial indicator for the success in a period must take into account both of the sides of the life of the business management simultaneously: profitability and liquidity.

These aspects summarize all the concepts of the success, both internal and the external of the business unit.

That's why the best indicator is the GSI (global success indicator):

RONA - PERCENT NET WORKING CAPITAL CYCLE FLUCTUATION.

The higher the better.

RONA gauges the return on the investments of the typical management in a period, the PERCENT NET WORKING CAPITAL CYCLE FLUCTUATION gauges, considering the difference in the respective days, if the company improves its time to collect than it improves the time to pay (delay) its suppliers.

If the PERCENT NET WORKING CAPITAL CYCLE FLUCTUATION is positive, it means that a worsening occured in that last period.

If an average sector benchmark is created, it is even more important.

If you wish to have more details, please go on page Contacts.

Whether you use standard costs into an extra accounting system or you incorporate them into your cost accounting system, the task you are entrusted with isn't easy.

If you are using the standard costs for control and performance evaluation purposes, you need to understand which model suits you best.

As I highlighted on the homepage, every element of your management control system must be set on the basis of your strategy.

If you are pursuing a cost leadership strategy, the best standard cost you have to set should be a demanding level.

The efficiency, for instance, about the direct labor and the usage about the material should be fixed at an ideal percentage.

This way of operating should allow you to lower the respective costs, keep the prices at a fair level and, as a result, to achieve the target profit.

Nothing more easy!

As a matter of fact, there are some countereffects.

The workforce could see the level of standards too high and in the long term the demoralization and the frustration, a demanding level could bring about them due to frequent failures of meeting them, could take hold.

As a result, the tasks would be performed without paying the right attention (in any case in the mind of people the standards are unattainable) and the desired efficiency and usage level shouldn't be achieved.

On the contrary setting the standards at a low level is not a good thing for a smart manager and for the objectives of the business.

The latter aspect is the risk a company with a differentiation strategy could run and that's why an attainable standard, taking into account also the experience of its workforce and the quality of material, the equipment on hand, is the best thing to set as a target.

You can say that this solution is good regardless of the strategy adopted.

I will be more  clear.

The cost leadership strategy requires a higher propensity to the level of efficiency than a differentiation one does, so it's wise to monitor it strictly during all the phases of the product life cycle, from the design to the delivery and aftersale stage, paying attention  to build the standards into the way of working of business people.

If the competition into a given market is high and the cost level are prominent, you can pursue the continuous improvement methodology.

This technique requires the setting of standards higher and higher over the time, by considering the gradual increase in the expertise and training of people in the manufacturing of the product or providing of the service, in the selection of material and in the use of the equipment.

In this case the performance evaluation should be made not on the basis of the deviation from the standards but of the progress to them.

The procedures of setting the standards are important, too, but this topic falls outside of this article.

The basis for  short term decision-making is the contribution margin  (CM) but the way it is achieved differs if there is a joint  production regardless of the further single processes after the split-off point (till that  the manufacturing cycle is one for all the products: none of the them can be eliminated).

I'll be short and to the point.

For every  kind of details you can get in touch with  me.

Products: X, Y

M: Raw material quantity

K: Conversion rate from a raw  material  unit  to an output quantity.

P: Selling  Price.

VCj: Variable  Costs of joint manufacturing cycle .

FCj: Fixed costs  of joint manufacturing  cycle.

WCM: Weighted Contribution Margin.

Pr: Profit.

If we make Pr equal  to 0:

0 = (Px - VCx) X M X Kx + (Py - VCy) X M X Ky - VCj X M - FCx - FCy - FCj.

0 = (CMx X Kx + CMy X Ky - VCj) X M - FC.

0 = WCM X M - FC

Break even point is:

M = FC/WCM