1. RELEVANT COST: Expected future costs that differ among alternative coursesof action.2. RELEVANT REVENUE: Expected revenue that differ among alternative coursesof action.3. INCREMENTAL COST: Change In Relevant Cost.4. SUNK COSTS: Past costs that cannot be changed no matter what action is taken.5. DISCRETIONARY COSTS: Arise from periodical decisions regarding outlay tobe incurred. Not tied to a clear Cause & Effect Relationship between Inputs &Outputs.6. ENGINEERED COSTS : Clear Cause & Effect Relationship between Inputs andOutputs7. OPPORTUNITY COSTS: Maximum available contribution to Profit that isforgone by using limited resources for a particular purpose.Decision Making : Relevant Costs & Relevant Revenues
Relevant RangeVOLUMECOSTRelevant RangeRelevant Time Period
Input-Process-Output Model MeasuresInput Measure Process Measure Output MeasureNon-FinancialNew # engineering # product delivery # new productsproducts hours milestones achieved introducedOrder # telephone order completion # ordersprocessing answering staff time processedParts # components setup time % output unitsmanufacture meeting specs meeting standardFinancialNew labour & Rs cost of % sales $ fromproducts materials Rs. prototyping new productsOrder clerical labour Rs cost of backorder Rs cost per orderprocessing Rs handling processedParts Rs cost of setup Rs cost Rs cost per unitmanufacture components cost of rework unit
Choosing What to Control (2)Control Inputs When Control Processes When Control Outputs Whenprocesses & outputs processes can be outputs can be observedare unobservable observed & measured & measuredcost of input is high cost of measuring/ cost of measuring/relative to value of monitoring process monitoring outputsoutput is low is lowquality and/or standardization issafety is important critical for safetyand/ or qualitycause & effect cause & effectrelationship is clear relationship is unclearproprietary processes innovation is desiredgive strategic advantage
Control alternatives• Controls can focus on:– the actions taken– the results produced– the types of peopleemployed and theirshared values andnorms.Or any combination of those ...Action ControlsResults ControlsPeople Controls
Control Alternatives (Mechant)Can people be avoided?(e.g., automation, centralization)Control-problemavoidanceCan you rely on people involved?Can you make people reliable?Have knowledge about whatspecific actions are desirable?Able to assess whetherspecific action was taken?Have knowledge about whatresults are desirable?Able to measure results?YesNoYesNoNoAction controlsPeople controlsResults controlsYesYesYesNoYesNo?Yes
Cybernetic Model - Single Feed BackEnvironmentPerformanceOperatingProcessSubordinateManagerSuperiorManagerBUDGETS / PLANSTASKSFEEDBACKFEEDBACKPlanning & Control Systems
Major Features of Budgets• A budget is a quantitative expression of a plan of action and an aid to co-ordination and implementation• The master budget summarises the objectives of all sub units of anorganisation. It quantifies management‟s expectations regarding futureincome, cash flows and financial positionROLE OF BUDGETS :* Planning of operations* Co-ordination of activities* Implementing plans* Authorizing actions* Motivating* Controlling & evaluating performancePLANNINGPERFORMANCE EVALUATIONCOMMUNICATION & CO-ORDINATION
Steps in Budget Preparation1. Sales / Revenue Budget2. Production Budget3. Factory Overhead Budget4. Inventory Budget5. Cost Of Goods Sold Budget6. Marketing & Admin. Exp Budget7. Profit Budget
Budget BasisFINANCIAL Actual Cost From the Most Recent Period Actual Cost from the Most Recent Period -Adjusted forexpected improvement Standard Costs – Based on an analysis of an efficientlyoperating manufacturing facility Target Costs – Based on analysis of the leading competitor inan industry Most Efficient Plant Costs – For a company with multipleplants having the same operations or producing the sameproductINTERNALINTERNALINTERNALEXTERNALEXTERNAL
Budget Basis (contd.)NON FINANCIAL MEASURESo Budgets & actual reults show the financial effects of how costdrivers are managedo Non financial measures are the primary means for exercisingcontrol on a continuing basis
Standard Costs• Carefully predetermined costs that are usually expressed on a per unitbasis. Standards outline how a task should be accomplished in nonfinancial terms & how much it should costStandard costs help management to:• Build budgets• Gauge performance• Obtain product costs• Save record keeping costs• Standard costs refer to the cost of a single finished unit of outputBudgeted costs refer to the total amount
Sources of Variance1. Inefficiencies in operations / breakdown of plan implementation2. Inappropriate standard3. Mis-measurement of actual results4. Parameter prediction error5. Randomness of operating processes
Variance Investigation Strategies• Investigate ALL variances• Investigate ALL variances greater than a specified percentagefrom standard• Investigate ALL variances greater than an absolute Rs. Amount• Investigate ALL variances on the basis of statistical controlcharts• Cost-benefit analysis of variance investigation decisions
Statistical Control Charts and Variance Investigation1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 19 20 21 22PERIODMATERIAL USE*OX******* ******OOOOOOOOOOOXXXXXX X X X X XPROCESS 1PROCESS 2PROCESS 3
Concerns with “traditional” Budgeting• Prevalence of the use of fixed performance contracts• Excessive amount of time spent on budgeting• Unpredictability of the environment• Budgets cannot help firm adapt to change• Budgeting‟s inherent disconnect with strategy• Extent of people‟s dissatisfaction with budgetingSource : Beyond Budgeting or Budgeting Reconsidered? A survey of North American budgeting Practice (Theresa Libby & R Murray Lindsay)
Criticisms of Budgeting• Involve (organizational) politics and gameplaying.• Encourage incremental, rigid thinking.• Centralizes power and stifles initiative.• Too much concentration on quantifiable, monetary and short termmeasures.• Focus on cost reduction, rather than value creation.• Too many costs for too few benefits.Possible reforms: rolling budgets, Balanced Score Card approach.Has the increased unpredictability and volatility that we now witnessmake budgeting less relevant?
Framework for Designing Performance Measurement SystemsStrategyWhat counts,getsmeasuredWhat getsmeasuredgets doneWhat getsdone getsrewardedWhat getsrewardedreallycounts!What you measure is what you get
Balanced Score Card (BSC)Designed to overcome the limitations of systems that are solely financiallyfocused. Key Success Factors (KSFs) are typically classified in fourperspectives:1. Financial perspective (financial measures)2. Customer perspective (customer satisfaction)3. Internal business process perspective (e.g., productivity and speed)4. Learning and innovation (e.g., training and number of new patentsor products)As can be seen above, the BSC focuses not just on financial factors but several non– financial factors as well
The 4 Perspectives of the BSCFinancialObjectives Measures Targets InitiativesIntl Business ProcessesObjectives Measures Targets InitiativesCustomerObjectives Measures Targets InitiativesLearning & GrowthObjectives Measures Targets InitiativesVisionandStrategyTo achieve our vision how should weappear to our customers?To succeed financially, howshould we appear to ourshareholders?To satisfy our shareholders andcustomers, what business processesmust we excel at?To achieve our vision, how will wesustain our ability to change andimprove?
• The fifth perspective for many organizations• The balancing of short-term and long-term goals in all three dimensions of thecompany’s performance–economic, social, and environmental:– Environmental reports use environmental performance indicators (EPIs) tomeasure sustainability– These indicators are in three areas:• Operational (measure stresses to the environment/regulatory complianceissues)• Management (try to reduce environmental effects)• Environmental condition (measure environmental quality)Sustainability
Using Leading and Lagging Indicators in Balanced ScorecardsLead FinancialperformanceLead CustomervalueLeadBusiness andproductionprocessefficiencyOrganizationallearning andgrowthLeading indicators Lagging indicatorLeading indicators are measures that identify future nonfinancial andfinancial outcomes to guide management decision making.Lagging indicators are measures of the final outcomes of earliermanagement plans and their execution.
Balanced Score Card (BSC)1.Financial and non-financial2.Leading and lagging3.Internal and external4.Quantitative and qualitative5.Short term and long termThe term “balanced” arises because contrasting perspectives areconsidered while measuring organizational performance
A strategy map is a cause-and-effect diagram of the relationshipsembodied in a BSC:– Shows how the achievement of CSFs in one perspective shouldaffect the achievement of goals in another perspective– The financial perspective is the target in the strategy mapbecause financial performance is the ultimate goal for mostprofit-seeking organizations– Success in the other perspectives leads directly to improvedfinancial performance and shareholder valueStrategy Map
Some Issues – BSC• Search for a balance of measures a tough task• Subjective measures causes uncertainty, gaming and behavioraldisplacements and hence costs• Tough balancing of finance and non finance measures, usually the financemeasures “win”!• There may be frequent need to change measures, parameters andweightingsBut a “correct” implementation of BSC clearly has many vital spin-off benefits ranging fromstrategy implementation to providing a basis for better evaluation of performance (?)
Balanced Scorecard – Problem Areas (example) Ongoing defect rate dropped from 500 to 50 ppm Yield increased from 26 to 51% One time delivery improved from 70 to 96% During the same period, the company’s performance showed littleimprovement and the stock price at the end of 1990 wasapproximately one-third of its July 1987 value!A large electronics firm made huge improvements in quality and on-timedelivery performance over a three year period 1987 -19901:Moral of the story : define measures with care and provide appropriate weighting
In sum ...• The BSC is future-oriented.• It is perhaps particularly useful if an organization that is undergoingsignificant change or if management wants to shift the strategic focus.• It is a costly process, but with demands for change in an organization,its benefits may outweigh the costs.
Beyond Budgeting• A break from the budgeting process, based on the growing need tosatisfy customers and optimise performance by relying on a company’sintellectual assets to manage an increasingly volatile and unpredictableenvironment with shifting product markets• This approach emphasizes:– rolling forecasts and optimization of resources– no evaluation on meeting specific targets– decentralized decision making and teams– a climate based on sustained competitive success– transparent and open information systems
Beyond BudgetingStresses the importance of culture and managing culture
Traditional Budgets & the Beyond Budgeting ModelTraditional (budget based)Mgmt. ModelBBM ModelTarget & rewards •Incremental targets•Fixed incentives•Stretch goals•Relative rewardsPlanning &controls•Fixed annual plans•Variance controls•Cont. planning•KPI’s & rolling forecastsResources &coordination•Pre-allocated resources•Central coordination•Resources on demand•Dynamic coord.Organ. & culture •Central control•Focus on managing #s•Local control ofgoals/plans•Focus on value creationSource : Beyond Budgeting in Statoil (Bjarte Bogsnes )
Empirical Evidence ? An Academic Viewpoint• BB presented as a universal prescription– Yet why do so many firms continue to use budgeting?– Some highly successful firms use budgeting extensively• Need deeper theory to explain why the BB model is superior• Assumptions (stated earlier) are under-researched and likely over-generalizedSource : Beyond Budgeting or Budgeting Reconsidered? A survey of North American budgeting Practice (Theresa Libby & R Murray Lindsay)
Some Issues to ponder• Keeping forecasts and targets different – does this create a problem?– What if the targets were achieved?– The system assumes targets may not be achieved and yet evaluatesmanagers on their achievement!• Performance targets for costs based on benchmarks.– Any adjustments done for size, technology, location?• Rolling financial plans clearly allow a better look-ahead.– But successful companies may be employing this technique anyway….– Also using „back of an envelope‟ estimates could jeopardize accuracy.Is necessary accuracy assured for long term financial plans?• KPIs based on benchmarks are a great idea, though some the concernssurrounding the BSC model need revisiting