Tag: University of Mumbai BMS Notes

Marginal cost formula helps in calculating the value of increase or decrease of the total production cost of the company during the period under consideration if there is a change in output by one extra unit and it is calculated by dividing the change in the costs by the change in quantity.

Marginal cost is the change in the total cost of production upon a change in output that is the change in the quantity of production. In short, it is the change in total cost that arises when the quantity produced changes by one unit. Mathematically, it is expressed as a derivative of the total cost with respect to quantity.

Marginal Cost = (Change in Costs) / (Change in Quantity)

where,

• Change in Total Cost = Total Cost of Production including additional unit – Total Cost of Production of normal unit
• Change in Quantity = Total quantity product including additional unit – Total quantity product of normal unit

Calculation of Marginal Cost

Step 1: Consider the total output, fixed cost, variable cost, and total cost as input.

Step 2: Prepare a production graph considering a different quantity of output.

Step 3: Find the change in cost i.e. difference of the total cost of production including additional unit and total cost of production of the normal unit.

Step 4: Find the change in quantity i.e. total quantity product including additional unit and total quantity product of normal unit.

Step 5: Now, as per the formula of Marginal cost divide change in cost by a change in quantity and we will get marginal cost.

This produces a dollar amount for each additional unit of a product that is produced.

The change in costs will greatly depend on the scale of production that is already in place. For instance:

• A baker working out of their home kitchen may be able to produce anywhere from one to fifty baguettes without a significant change in costs since they can continue using the same oven in the same room. (Their largest cost increase in going from a single loaf to a 50-loaf production run would be the extra flour, salt, water, and yeast all quite low as far as raw materials go.)
• However, if the baker wants to scale up to producing hundreds of baguettes, they will probably need to start working in a much larger space than their home kitchen. In this case, increasing the quantity of output will result in a much greater fixed cost, since they will probably have to lease space in a larger facility, and perhaps purchase new equipment.
• Increased production costs do not necessarily indicate diminished total revenue. To the contrary, most businesses lower their per-unit cost of production by increasing their level of output. This ties to the principle of “economies of scale.” As the level of production increases, the average cost per unit produced tends to go down provided, of course, that there is a sufficient market for consumers willing to purchase your product.

Managerial Uses of Marginal Costing:

(a) Cost Ascertainment:

Marginal costing technique facilitates not only the recording of costs but their reporting also. The classification of costs into fixed and variable components makes the job of cost ascertainment easier. The main problem in this regard is only the segregation of the semi-variable cost into fixed and variable elements. However, this may be overcome by adopting any of the methods in this regard.

(b) Cost Control:

Marginal cost statements can be understood easily by the management than those presented under absorption costing. Bifurcation of costs into fixed and variable enables management to exercise control over production cost and thereby affect efficiency.

In fact, while variable costs are controllable at the lower levels of management, fixed costs can be controlled at the top level. Under this technique, management can study the behaviour of costs at varying conditions of output and sales and thereby exercise better control over costs.

(c) Decision-Making:

Modern management is faced with a number of decision-making problems every day. Profitability is the main criterion for selecting the best course of action. Marginal costing through ‘contribution’ assists management in solving problems.

Some of the decision-making problems that can be solved by marginal costing are:

(a) Profit planning

(b) Pricing of products

(c) Make or buy decisions

(d) Product mix etc.

Limitations of Marginal Costing:

(a) Segregation of all costs into fixed and variable costs is very difficult. In practice, a major technical difficulty arises in drawing a sharp line of demarcation between fixed and variable costs. The distinction between them hold good only in the short run. In the long run, however, all costs are variable.

(b) In marginal costing, greater importance is attached to the sales function thereby relegating the production function largely to a secondary position. But, the real efficiency of a business is to be assessed only by considering the selling and production functions together.

(c) The elimination of fixed costs from the valuation of inventories is illogical since costs are also incurred in the manufacture of goods. Further, it results in the understatement of the value of stock, which is neither the cost nor the market price.

(d) Pricing decision cannot be based on contribution alone. Sometimes, the contribution will be unrealistic when increased production and sales are effected, either through extensive use of existing machinery or by replacing manual labour by machines. Another possibility is that there is danger of too many sales being affected at marginal cost, resulting in denial to the business of inadequate profits.

(e) Although the problem of over or under absorption of fixed overheads can be overcome to a certain extent, the same problems still persists with regard to variable overheads.

(f) The application of the technique is limited in the case of industries in which, according to the nature of business, large stocks have to be carried by way of work-in-progress (e.g. contracting firms).

Some of the areas where a cost control is essential in a Business are:

(I) Labour

(ii) Materials

(iii) Sales

(iv) Overheads

(v) Energy

Costs have been rising faster than ever before. The business executives have neglected the more important task of providing effective information to management for the control and reduction of costs. The management and control of the resources used in most business firms leaves a great deal to be desired.

(i) Labour:

Labour costs have risen in three ways:

(a) Higher basic pay,

(b) Shorter working hours, and

(c) Reduced output.

Reducing labour cost is a little tricky question. It is not possible to reduce wage rates due to the existence of trade unions and minimum wage legislations. The policy of wage reduction is also counter­productive for a management. So to motivate the workers, wage rates would need to be revised up­wards. The reduction in labour costs would be possible only if over time, the rate of output per worker increases faster than the wage rate increase. This is possible by raising labour productivity.

Productivity schemes aimed at paying for more output are self-defeating unless the net result is a reduction in unit cost.

Productivity must be seen as one or other of the following:

(i) Producing more for the same cost, or

(ii) producing the same for a lower cost.

Productivity should mean lower unit costs it is, in other words, cost reduction. This means finding better ways of doing things so that production increases for each hour’s efforts expanded. This is the only way to defeat rising labour costs.

(ii) Material:

The inefficient use of materials is one of the prime causes of increased costs. Wastage through poor control and design has risen to such an extent that waste recovery is now a major industry. Waste must be controlled if costs are to be contained.

The price paid for materials is affected by commodity markets. There are different ways of reducing material cost. If purchasing of materials is done properly, the firm can get various types of discounts. A number of decisions are involved in the case of materials used by a firm.

• Firstly, the sources where materials are available will have to be identified.
• Secondly, a cheaper substitute available to the material being presently used by the firm has to be found out.
• Thirdly, the cost of freight has to be examined.
• Fourthly, a suitable product design to reduce the material usage is needed.
• Fifthly, alternative process of production has to be examined.

Since material cost form a major part of the total cost of production, control and reduction of material cost in these cases is of vital importance. R&D efforts, inventory management, improved production planning, elimination of slow moving stocks, and improved flow of parts and materials, etc. can be effective in controlling and reducing these costs.

(iii) Sales:

Sales are another area which needs monitoring of costs. Sales control requires making sure that the company is not over-spending to achieve its sales goals. In order to sell, a firm maintains a sales force and spends on advertisement, etc. The key ratio to watch is marketing expense to sales.

It consists of five component expenses to sales ratios:

(i) Sales force to sales

(ii) Advertising to sales

(iii) Sales promotion to sales

(iv) Marketing research to sales

(v) Sales administration to sales.

Management needs to monitor these marketing expense ratios. Sales cost can be controlled by rearranging market segments as the basis of demand. It should reschedule the sales force based on suitability of each member of the team. Peculiarities of consumer choices must be ascertained and communicated to the management, so that products are altered according to consumer needs.

(iv) Overheads:

Overhead costs are fixed costs. Fixed costs are defined as those which remain the same at a given capacity and do not vary with output. These costs will exist even if no output is produced. A proper selection of capacity, a right choice of equipment and its proper maintenance are likely to keep over­heads down.

The costs of plant, equipment and building, etc. are examples of fixed cost. Included in them are costs that require a fixed amount of funds in each period without reference to output such as rent, depreciation charges, property taxes and salaries of employees who cannot be retrenched during peri­ods of reduced demand. Careful planning is required regarding the complete layout of the plants. The overhead costs can be reduced by means of effective planning and implementation.

(v) Energy:

Faulty designs result in excessive use of power and materials. Lighting costs can be reduced by high quality electronic energy saving light bulbs. The increase in oil prices has shown the very high levels of waste. The problem of energy conservation is attracting considerable interest because high prices warrant some action.

The costs of reducing the consumption of energy can now be offset by the savings. Yet there has always been value in reducing energy consumption. Changing attitudes towards the use of what has always been cheap and plentiful is difficult, yet the task must be tackled if the pressure on profits is to be reduced.

It is stated that, in India, there is no economy in the use of fuel, energy or power. Fuel wastage in Indian industry is as high as 25 per cent. All these areas of rising costs must be tackled if industry and commerce hope to survive intact. They can only be tackled if a continuous examination of resource consumption is instituted. Only a well thought out and continuous cost reduction programme will produce the necessary long term benefits.

Cost Reduction Program

Followings are the essentials of a cost reduction program:

• Cost reduction program should be according to requirement of the company.
• Cost reduction program is a continuous activity that cannot be treated as one time or short-term activity. Success of any cost reduction program may lie in only continuous improvement of efforts.
• Cost reduction program should be real and permanent.
• Example setter of cost reduction program should be top management employee. Success of this program depends on co-operation of all employees and department of an organization.
• Employees should be rewarded for their participation in cost reduction program and for giving innovative ideas related to this program.

Fields Covered under the Cost Reduction Program

A number of fields come under the scope of cost reduction. They are discussed below.

Design

Manufacturing of any product starts with the design of product. At the time of improvement in design of old product as well as at the time of designing new product, some investment is recommended to find a useful design that may reduce the cost of the product in following terms:

Material Cost

Design of product should encourage to find out possibility of cheaper raw material as a substitute, maximum production, less quantity etc.

Labor Cost

Design of product may reduce time of operation, cost of after-sale service, minimum tolerance, etc.

Organization

Employees should be encouraged for cost reduction scheme. There should be no scope for doubts and frictions; there should be no communication gap between any department or any level of management; and there must be proper delegation of responsibilities with defined area of functions of an organization.

Factory Layout and Equipment

There should be a proper study about unused utilization of material, manpower and machines, maximum utilization of all above may reduce cost of any product effectively.

Administration

An organization should make efforts to reduce the cost of administrative expenses, as there is ample scope to do so. A company may evaluate and reduce the cost of following expenses, but not the cost of efficiency:

• Telephone expenses
• Travelling expenses
• Salary by reducing staff
• Reduction in cost of stationery
• Postage and Telegrams

Marketing

Following areas can be covered under the cost reduction program:

• Advertisement
• Warehouse
• Sales Promotion
• Distribution Expenses
• Research & Development Program

Any cost accountant should keep the following points in mind while focusing on cost reduction for the Marketing segment:

• Check the distribution system of an organization about the overall efficiency of the system and how economically that system is working.
• Find out the efficiency of the sales promotion system
• Find out if the costs can reduced from the sales and distribution system of an organization and whether the research and development system of market is sufficient.
• A cost accountant should also do an ABC analysis of customers in which customers may be divided into three categories. For example:

ABC Analysis of Customers
Category	Number of Dispatches	Volume of Sale Covered
Customer…A	About 10%	60% to 80%
Customer…B	About 20%	20% to 30%
Customer…C	About 70%	5% to 10%

After performing this analysis, the organization can focus on the customers who are covering most of the sales volume. According to it, the cost reduction program may be run successfully in the area of category B and C.

Financial Management

Attention should be given to the following areas:

• If there is any over-investment.
• How much economical is the cost of capital received?
• If the organization is getting maximum returns for the capital employed.
• If there is any over-investment, that should be sold and similarly, unutilized fixed assets should be eliminated. Slow-moving or non-moving inventories should be removed and should transfer this surplus to the working capital to re-invest it in a cycle of more profitable area of business.

Personal Management

Cost reduction programs can be run using staff welfare measures and improving labor relation. Introduction of incentive schemes for labor and giving them better working conditions is very important to run an efficient cost reduction program.

Material Control

Cost reduction program should be run by purchasing economical and more useful material. Economic Order Quantity (EOQ) technique should be used. Inventory should be kept low. Proper check on inward material, control over warehouse and proper issuance of material, and effective material yield should be done.

Production

Using effective control over material, labor, and machine a better cost reduction program may be run.

Performance Management Information Systems identifies the accounting information requirements and the types of information systems used; describes and identifies the main characteristics of transaction processing, management information and executive information systems; and defines the good and bad of open and closed systems with regard to performance management.

Different types of information systems used for strategic planning, management control and operational control and decision-making.

Accounting information can be drawn from both internal and external sources and is used to create plans and for decision making.

• For strategic planning, information about competitors, profitability of products, customer profitability, pricing decisions and the value of the market share are useful in order to set goals and create a strategy.
• For management control, information about resources, efficiency and effectiveness is required to set targets and objectives. Much of this information can be generated internally.
• For operational control, information about the operations, transaction data (e.g. customer purchases), detailed operating information that is expressed in the right units is used to organize day to day tasks and activities.

Management information systems include transaction pro cessing systems, management information systems, executive information systems and enterprise resource planning systems.

1. Transaction processing systems (TPS)

Transaction processing systems (TPS) “collect, store, modify and retrieve the transactions of an organization” and are characterized by:

• Controlled processing
• Inflexibility
• Rapid response
• Reliability

2. Management information systems (MIS)

Management information systems (MIS) “convert data into information” and are characterized by the following:

• Provide support for structured decision
• Are designed to report on existing operations
• Have little analytical capability
• Inflexible
• Focus on the internal

3. Executive information systems (EIS)

 Executive information systems (EIS) use data from the MIS and allow to create a “generalized computing and communication environment.” Characteristics include:

• User friendly interfaces
• Interactive tutorials that visualize situations
• Links to external databases
• Tracking of critical information

4. Enterprise resource planning systems (ERP systems)

 Enterprise resource planning systems (ERP systems) are software packages that pull together the organization’s processes into one system. Some characteristics are:

• Can be accessed by anyone who’s computer is linked to the central server
• Has decision support features
• Can be linked to external systems
• Works well for global operations
• Allow for standardization of information and work practices

When it comes to a management report, the key areas that you focus on are the profits and losses amongst your clients, products, geographic regions, and even the company’s departments. The first step would be to have a computerized system develop the necessary data, which is collected by a mid-level manager and written up using the following reports:

1. Cash Flow: This report provides the monthly transactions for your bank, which includes your company’s expenses and liabilities, along with the income you have received. For example, by analyzing your cash flow, you may realize that you had a $30,000 increase in accounts receivable. The increase could be that your client was invoiced for $50,000, but you only received $20,000. The amount in accounts receivable is the difference. This is only one of many examples of how there could be a difference between the cash in your bank and the profit in your reports, which is easily explained with this amazing cash flow tool.
2. Balance Sheet is a summary of the company’s assets, retained earnings, and liabilities are shown on this report. This report delivers an accurate evaluation of your company’s worth (e.g. vehicles, equipment, and cash on hand) minus what has to be paid (e.g. suppliers, future bills). Using a balance sheet, you can easily discover which clients are behind on their payments and how much money is owed to you. And you also have the option of comparing the sales from a previous month to the current month. This tool goes as far as averaging the revenue per customer and the amount of sales that each salesperson generated.
3. Profit and Loss is income from sales, minus expenses that are generated on a daily basis. The report will divide your expenses into their necessary spending categories. Maybe you want to average out your numbers for the year. You can do this by viewing your sales and expenses on a quarter-to-quarter or month-to-month basis. Now, you will know which months or quarters are the strongest for your company and which ones you have to work on. You can even view the numbers by a specific team, department, or assignment.
4. Sales: one of the most important reports is the sales report, because it generates information about the invoices that were raised for the past month.
5. Trade Creditor is a list of all the businesses that you have to pay.
6. Trade Debtor is a record of all the clients that have invoices with your business and still owe you money.

Importance of Management Reports

1. You can discover trends and make the best decisions

Whenever you perform a financial report, you know exactly if the company is gaining or losing. The only downside is that you don’t know exactly how and why this may be happening. There is no benefit in simply knowing that you are winning or losing. With a management report, you are able to go within the workings of your company to see what is actually causing your company to win or lose. Even better, you can find out what areas need work and which parts of the company are the strongest. This is necessary, because you could have a profit for the year and still have a weak link within the company. This issue could be preventing you from making even more money for the company. Are you in business to leave money on the table?

2. Prevent any unnecessary losses and expenses

And with the world of business constantly changing, it is critical to know when and where you may need to make some adjustments within the company. You definitely don’t want to be the company that reacts, after it is too late. By then, your business is in the hole and you have a lot more to lose.

3. A powerful tool that delivers up-to-date information about your company

With a management report, you always have the upper hand and can easily adjust to the new changes in business. This is a strategic tool that can be used for long-term plans of growth and profits. Investing in an informative management report is a no-brainer for any organization. Invest in your future today and make sure you have the best Corporate Service Provider to cover your back from registration of your business in the UAE to monthly management reports and annual reporting.

Every business is a little different, but as a starting point for many of our clients we like to look at the following items. You’ll notice this might seem a little sparse, and that’s by design. Too much information is almost worse than no information, so we like to focus on what really matters in your business and nothing else.

1. Budget

A well-crafted budget is a beautiful thing indeed. It will enable you to set a path for the business to follow over the coming year(s) and give you a framework within which to operate the business and achieve your goals. What do we need to do in sales next month? Check the budget. How much can we spend at the office party? Check the budget. Typically you’ll set a new budget each year and periodically update the budget during the year as new information comes to hand.

2. Cash flow

The lifeblood of any business, it’s important to know what cash flow is doing in your business. Unless you’re in dire straits there is no need to micro-manage cash, but you should be able to report on what the future cash balance is for the business over the coming year as well as know what kind of state your trade receivables are in.

And finally we like to look at a some Key Performance Indicators. These will vary business by business, but below are a few that we recommend for most service businesses.

3. Wage Revenue ratio

Too often we’re not getting a good return on our wage spend so it’s a wise idea to track this carefully. A good goal is to spend no more than 65% (ideally, less) of revenues on labour costs. And remember that when we talk about revenue we really mean gross profit (i.e. sales less direct costs).

4. Staff productivity

This one helps you dig into the reasons behind revenue shortfalls as it shows which staff are hitting their personal productivity targets and which are not. Some businesses will report on hours, others on revenue generated, but either way there is accountability on a per-head basis. We would also consider write-offs per team member here as well.

5. Client/job profitability

This information will let you know which clients or job types are profitable in your business and those which are not. Regular analysis here may lead to letting certain clients go, re-quoting other clients, redesigning or ditching certain service offerings all in the pursuit of profit.

Five items. That’s it. With the information gathered from these five items you should have most, if not all, of what you need for a really useful set of management reports. From here we can see if we’re hitting our targets, keep an eye out for future cash dramas, and find out which staff/clients/jobs are helping or hindering the bottom line.

Performance Analysis in Private Sector Organizations describes financial performance indicators; describes non-financial performance indicators; analyses past performance; explains the causes and problems created by short-termism and financial manipulation of results; explains the Balanced Scorecard and the Building Block Model and discusses the difficulties of target setting in qualitative areas.

Performance Analysis in not for Profit Organizations and the Public Sector

Not for profit organizations have general objectives which include:

• “Surplus maximization (Similar to profit maximization)
• Revenue maximization
• Usage maximization
• Usage targeting (Matching the capacity available)
• Full/ partial cost recovery (Minimizing subsidy)
• Budget maximization: Maximizing what is offered
• Producer satisfaction maximization: Satisfying the wants of staff and volunteers
• Client satisfaction maximization: Generating the support of the public”

Performance could be measured in Private Sector Organizations through:

Performance can be measured using the value for money criteria of economy, effectiveness and efficiency.

• Economy is spending money frugally
• Efficiency is getting the most for the money spent.
• Effectiveness is getting what has to be done economically and efficiently
• Public sector organizations

Public sector organizations come in many shapes and forms. The most obvious examples are schools and hospitals, police forces and local transport providers, but there are many less visible organizations such as regulatory bodies. The objectives of public sector organizations are very different from those of commercial organizations, and this can make performance management more complicated. The following factors in particular differentiate public sector organizations from commercial:

1. They have a broader group of stakeholders than commercial organizations. This can lead to greater conflicts. Commercial organizations are likely to be mainly concerned with shareholders, employees, customers and their lenders. Public sector organizations are likely to be interested in pleasing the providers of funding (the government), the users of the service and the taxpayer. In the case of schools, for example, parents would be happy to see more money spent on education but, as taxpayers, they may not wish to pay more taxes.
2. Customers do not pay directly for the services they receive, and there may be little relationship between the costs of providing the service and the amount it is used. Consider a subsidised bus service, for example. The daily costs of running the buses are likely to be largely fixed, and do not depend on the number of passengers using them at least in the short term. This makes it harder to decide how much should be spent on the service.
3. Many public sector organizations operate as monopoly providers. Even if customers are not happy with the service they receive, they cannot switch to an alternative supplier. In commercial organizations, this is generally not the case, and bad performance will lead to a loss of customers and, therefore, loss of funding.
4. The output of public sector bodies is often difficult to measure. How do you determine how much work a police force has performed? Statistics such as the number of crimes reported may be used. If the police force is doing a good job however, and crime is falling, the number of crimes reported may fall. So the lower number of crimes reported would wrongly suggest that the police force is not working so hard.

There is a perception that performance in public sector organizations is poorer than in the private sector, both in terms of efficiency and quality of service.

Performance measurement is the performance based management process which is flowing from the organizational mission and the strategic planning process. Divisional performance measurement includes the objective and subjective assessments of the performance sub-units of an organization such as divisions or departments. Divisional performance measurement are effective in ensure that a strategy of organization is successfully implemented by monitor a divisions effectiveness in satisfying its own predetermined goals or stakeholder desires. Divisional performance measures may be based on non-financial as well as on financial information.

Measurement of Divisional Performance

Method 1. Return on Investment (ROI)

Many organizations use return on investment (ROI) to measure divisional performance. ROI expresses divisional profit (operating profit) as a percentage of assets employed in the division. Some companies use net profit after tax as the numerator in calculating the ROI.

Decid­ing on the denominator is a complex decision. Many companies allocate corporate equity to different divisions on some equitable basis (e.g., proportion of total assets employed in each division) and use the same as a denominator.

Some firms use capital employed, (i.e. fixed assets + working capital) as the denominator. However, considerable variations are found in practice on how working capital is treated. Many firms use gross working capital particularly if divisional managers have no influence on trade creditors or other current liabilities. Others prefer to use net working capital as it provides a good measure of corporate resources allo­cated to the business, and managers are expected to earn an adequate return on the same.

Many organizations use book value of fixed assets in calculating capital employed in the division. However, use of book value often misstates the division profitability. Use of book value reduces capital employed and increases ROI every successive year without any real improvement in economic performance. Therefore, use of book value may not motivate divisional manages to acquire new fixed assets.

Better alternatives are the use of replacement cost or the original cost of acquisition (gross book value). However, use of replacement cost or original cost presents some practical problems because it is difficult to ascertain replacement costs of different assets acquired at different points of time having different residual values. If original cost of an asset is used managers may be motivated to dispose of assets even if they have some usefulness.

Companies prefer to use net book-value methods in preference to others because non-accounting methods have an element of subjectivity, while financial accounting methods have an aura of reality for operating managers. The selection of a particular method ultimately depends on the assessment of corporate management of what practice would induce divisional man­agers to efficiently use resources and to acquire proper amount and kind of new assets.

The following are the advantages of ROI for measuring divisional performance:

(a) It is a comprehensive measure and captures all the factors which influence figures in financial statements.

(b) It is easy to calculate and understand.

(c) It makes comparison of performances of different divisions easy.

(d) Data on ROI of different companies are easily available and that helps in inter-firm comparison.

In spite of these advantages many companies do not use ROI for measuring divisional performance because it has the potential to create serious dysfunctional effect.

Use of ROI may motivate divisional managers to avoid acquisition of assets which would decrease the ROI of the division even though it would improve the performance of a company as a whole. E.g., if the current ROI of a division is 20% it would not acquire an asset which would earn a return of 18% although the weighted average cost of capital of the company is 15%.

Thus ROI creates a bias towards no or little additional investment. Man­agers may also take wrong asset disposal decisions. Similarly, a division which has a very low ROI may be tempted to improve ROI by acquiring assets which will improve its ROI although its earning will be lower than the cost of capital of the company.

In view of this serious limitation, many companies use ‘RI’ as a measure of divisional performance.

Method 2. Residual Income (RI) or Economic Value Added (EVA)

Residual Income is pre-tax profit less an imputed interest charge for invested capital.

The imputed interest charge is often referred to as capital charge in management literature. This capital charge is found by multiplying the amount of assets employed by a rate. Selecting the rate of capital charge also poses some problems.

The simplest method is to use company’s cost of capital. However, a sophisticated method uses different rates for different classes of assets may be one rate for general-purpose assets, while a special rate for special-purpose assets.

Some companies use a rate which is close to the company’s cost of borrowing rather than to its cost of capital.

While ROI is a ratio, RI is an absolute figure. RI deals with the problems of ROI adequately because any investment, which will earn higher than the capital charge will improve the RI. Therefore, use of RI motivates divisional managers to acquire only those assets, which will improve the performance of the company as a whole. Thus, the RI method sets the same profit objective for same assets in different divisions.

A sophisticated system also solves the problem of the same profit objective for different assets in the same division by using different rate of capital charges for different class of assets. RI is definitely a superior measure compared to ROI for measuring divisional performance.

Stern Steward & Co., a consultancy firm in USA, uses the term EVA for RI. The Stern Steward & Co. suggests many adjustments to correct the distortions in reported profit and capital due to accounting bias towards prudence. Many firms use EVA as the basis for cal­culating variable part of the executive compensation to induce managers to behave like owners, who in a business to create wealth for themselves.

External considerations in performance management can have an impact on how the organization performs and the steps to be taken to improve performance.

Stakeholders can have an interest and can be impacted by the organization’s activities. Examples of stakeholders are customers, competitors, employees, suppliers, lenders and the community.

Market conditions can impact performance and include “factors as economic growth, inflation, interest rates, exchange rates, government fiscal policy.”

The allowance for competitors includes monitoring “competitors” prices and cost structures” and features that add value and could lead to increased market share.

Performance measures should ensure that stakeholder needs are met, there are plans in place to deal with changes in the market and provide a basis for comparisons with competitors.

Performance measures vary for each of the external considerations. Examples are:

• Employees: Motivation, morale
• Management: Salaries, profit sharing
• Shareholders: Price of shares, dividend yield, earnings per share
• Customer: Price, quality, service, value for money
• Government: Taxation, inflation, exports, employment
• Community: Environmental impact, employment, social needs

The factors affecting pricing decisions are varied and multiple. Basically, the prices of products and services are determined by the interplay of five factors, viz., demand and supply conditions, production and associated costs, competition, buyer’s bargaining power and the perceived value. We would like to divide them as Internal Factors and External Factors.

Internal Factors

1. Marketing Objectives and Pricing Objectives

Pricing objectives may be as stated earlier profit objectives (return on sales investment and maximisation of profits), sales objectives (increasing sales volume and increasing market share) and maintenance objectives (price stabilisation and matching the competition). Various pricing objectives have important implications for a firm’s competitive strategy. Pricing objectives must not be in conflict with the marketing objectives of the firm.

2. Marketing Mix Strategy

Price of a product or service is highly influenced by other elements of marketing mix. The product life cycle through which the product is passing through, or the kind of sale (lease versus overnight purchase, or liberal returns policy may be followed). In the introductory product life cycle or liberal returns policy, the price is likely to be high. If the product requires services and those services are to be provided free, naturally the product will be highly priced.

The channels of Distribution, location of warehousing and the transportation involved also influence the price determination. Direct to the customer may enable the manufacturer to charge a lower price, but selling through many intermediaries mean the final price is to be very high to compensate the efforts of intermediaries.

Promotion efforts reflect into final price. The amount of money spent by, Coke and Pepsi, HUL or Proctor & Gamble reflect in the prices to be charged. If the intermediaries are to undertake promotion work, they will be charged a lower price and vice versa.

3. Costs

Cost of a product is the single most important factor to influence the final price. Six steps need to be identified while evaluating cost-price structure:

• Define the existing price structure;
• Identify the prices of competing products for each item in the product line;
• Decide which product items need attention;
• Calculate the profitability of the current product/service mix;
• Identify products and services for price changes; and
• Define the new price structure in the company.

4. Organizational considerations

All the marketers are to make profit. Profit is a function of costs, demand, and revenue. Hence their relationship must be understood by pricing managers. The costs may be fixed costs and variable costs. Break-even analysis is one unique technique to understand relationship between cost and price.

External Factors

1. Nature of the market and demand

What is the expectation of the market about the product or services? What is the demand level for the product at different prices?

Market must also be understood whether there is monopoly, perfect competition, oligopoly, monopolistic competition or duopoly.

To understand demand, the supplier or marketer prepares demand curves for the product at different prices. The marketer prepares separate curves for normal products and prestige goods. In addition to understanding price and quantity relationship, the marketer must determine the price elasticity of demand to understand price sensitivity of customers.

2. Competition

There might be pure competition (Many buyers and Sellers Who Have Little Effect on the Price), Monopolistic Competition (Many Buyers and Sellers Who Trade over a Range of Prices), Oligopolistic Competition (Few Sellers Who Are Sensitive to Each Other’s Pricing/ Marketing Strategies), or Pure Monopoly (Single Seller) and in each situation price determination will be different.

The competition may arise from different sources: Directly similar products like Coke and Pepsi, available substitutes speed post versus couriers, or unrelated products seeking the same rupee cricket match versus cinema, coke versus juice, new year dinner versus vacation for three days, etc.

Though many customers have poor price knowledge, yet retailers can’t charge more than the competitors. Retailers often give price guarantees either by way of price-matching policies (prices will not be higher than the prices charged by other retailers) or best price policies (protecting customers against future discounts). Four strategic options are available to a firm: Build (price lower than the competition), Hold (reduce price if competitor reduces), Harvest (much greater resistance to match price cuts for the products that are being harvested), and Responsive (repositioning to force change in price).

3. Other Environmental Factors (economy, resellers, & government)

Economic Conditions, Reseller Needs, Government Actions, Social Concerns do play an important role in price fixation.

Inflation in economy is an important factor in pricing. In India during the last two years the inflation has been a great burden on the common man and even the government has failed to do anything. During recessionary conditions, the price level also drops, to maintain the same level of turnover. Presently due to increased interest rate by Reserve Bank of India, the manufacturers have to pay a higher cost of capital which will be reflected in the price to be charged.

Resellers needs are important in price determination. If you remember, petrol pump dealers went on strike a number of times and finally the oil marketing companies had to agree the margin for the resellers. It will naturally reflect in the final price to be charged to the consumers. In some cases, like butter, the retailers have to manage facilities like deep freezers which have both a capital cost and operating cost, the manufacturer will have to provide a larger margin to them.

The needs of intermediaries must be kept in mind otherwise product launches may not be viable. In February 2012, Maruti Suzuki for the first time in a decade increased Dealers’ margin on Petrol Cars by 10% as the sale has been going down and the dealers were earning merely 4% after discounts and freebies. The revision follows the increase in retail prices. Hyundai Motors and Volkswagen offer 7% by way of commission.

Government’s concerns about pricing are reflected in laws and regulations. Government regulations include price controls, import duties, quotas and taxes. Recent decline of rupee value vis-a-vis dollar also affects the prices of imported products or products using imported spares. The volatility in international markets also affects the prices at home.

The oil marketing companies were left with no alternatives except to increase price of petrol, when the oil prices in international markets went up. Public policy influences of the state include the pricing environment (many governments have gone with the winds of inflation remember, the Sushma Swaraj government of Delhi had to go because of onion price rise). In case of essential drugs the Department of Pharmaceuticals (DoP) regulates the prices. Recent decion of the Government of India to grant compulsory license to Natco Pharma to produce Bayer’s anti-cancer drug could pave the way for cheaper drugs for lifestyle diseases.

4. Willingness to Pay

Knowledge of consumers’ reservation price (“the price at which a consumer is indifferent between buying and not buying the product”) or willingness to pay (“reservation price at which the consumer’s utility begins to exceed the utility of the most preferred item”) is central to any pricing decision. Willingness to pay is important not only for pricing but equally important for new product development, value audits and competitive strategy.

Knowledge of consumers’ reservation prices also allows marketer to understand three demand effects due to change in price – the customer switching effect, the cannibalisation effect (when consumers derive more surplus from a new product offering than from the existing products, and the market expansion effect (non-category buyers now derive more positive surplus from the new offering).

5. Product Line Differentiation

For vertically differentiated product lines, companies are able to charge higher prices. Companies often add a high price product into the line to increase the demand for a product with middle-level price. For products in a horizontally differentiated product line tend to be uniform. Retailers charge the same for different flavours of yogurts, same price for clothes of different sizes. All the car manufacturers have different prices to cater to different market segments, namely economy cars, family saloons, executive cars, and so on.

6. Positioning Strategy

Positioning strategy involves the choice of target market and the creation of a differential advantage. Price can be used to convey this differential advantage and to appeal to a certain market segment. Price is a powerful positioning tool for many people as an indicator of quality, especially in products like drinks, perfume, and services where quality can’t be assessed before consumption.

7. New Product Launch Strategy

While launching new products, price should be carefully aligned with promotional strategy. High price and high promotion is called a rapid skimming strategy. One company that uses skimming strategy effectively is Bosch. Its skimming Price Policy is supported by a large number of patents, to its launch of fuel injection and anti-lock brake systems. High price (skimming) and low price (penetration) may be appropriate in different situations.

Quantitative Analysis in Budgeting analyses fixed and variable cost elements from total cost date using high/ low method; explains how to estimate the learning rate and learning effect; applies the learning curve to a budgetary problem; discusses the reservation with the learning curve; applies expected values and explains the problems and benefits and explains the benefits and dangers of using spreadsheets in budgeting.

Quantitative Analysis in Budgeting

1. Analyse fixed and variable cost elements from total cost data using high/low method.

The high-low method is a “quantitative technique for analyzing costs into their fixed cost and variable cost elements.” It is used to separate the total cost into fixed and variable costs.

Here are the steps to be followed when using the high-low method:

Step 1: Review records of costs in previous periods

• Select the period with the highest activity level
• Select the period with the lowest activity level

Step 2: Adjust by indexing up or down

Step 3: Determine the following:

• Total costs at high activity level
• Total costs at low activity level
• Total units at high activity level
• Total units at low activity level

Step 4: Find the variable cost per unit (v)

• Formula: (Total cost at high activity level – Total cost at low activity level) ÷ (Total units at high activity level – Total units at low activity level)

Step 5: Find the fixed cost

• Formula: (Total cost at high activity level) – (Total units at high activity level x variable cost per unit)
• Estimate the learning rate and learning effect

Learning curve theory is used in situations where the workforce improves in efficiency when they gain more experience. Where there is a learning curve, there is a learning rate and a learning effect.

The learning rate is “expressed as a percentage value.”

The learning effect is that “as the workforce learns from experience how to make the new product, there is a big reduction in the time to make additional units.”

Apply the learning curve to a budgetary problem, including calculations on steady states.

There are two main approaches that are used to calculate the learning curve:

• The Tabular approach: uses a table to calculate the cumulative average time per unit and the total time to produce all the units produced so far
• The Algebraic approach

To calculate the learning curve using the algebraic approach, the following formula is used:

Formula: Y = axᵇ

• Y is the cumulative average time per unit to product x units
• x is the cumulative number of units
• a is the time taken for the first unit of output
• b is the index of learning (logLR/log2)
• LR is the learning rate as a decimal

Importance of Budget

Before we get into adding a new system, let’s review some of the basics of goals and uses of a budget.

1. Financial Resource Allocation

Money is the lifeblood of a company. Having enough of it to support operations, new business initiatives and acquisitions is vitally important. The budgeting process is essentially matching what is possible with the resources that exist.

Strategic Plan Support: The budgeting process should focus on the important steps you must take during the year to support your strategic plan. It should lay out the coordination of the departments and set the benchmarks to signal if the plan is succeeding.

Initiative Tracking: New initiatives are often the basis for growth. As they are an unknown territory, the assumptions made for revenues and costs usually have a wider range of possibilities. Once the year begins, the budget serves the purpose of tracking chosen initiatives to gauge their success or failure.

Expense Control: Budgets provide feedback to managers as to their performance and should incentivize them to take corrective actions when necessary, and identify overperformance and possible opportunities.

Some Basic Budgeting Best Practices

Before we get into an example of adding a quantitative methodology, I want to go over some best practices for budgeting in general. While certainly not exhaustive, I have found that these steps will save time and resources by reducing budget iterations and improving department coordination.

Set a Timeline: While obvious, the timeline should be detailed enough to allow for individual department budgeting, cross-departmental reviews and consolidated working budget reviews. I have seen companies doing budget consolidation reviews only days before a board meeting.

Convey Topline Guidance Early: Having a budgeting process commence by clarifying all top and bottom line goals and distributing the information to managers can save a lot of time later in the process. As a recent example, a COO told me about having done a budget with 8% growth, but the firm’s PE investor wanted to see 20%, so they had to go through the whole process again.

Team Collaboration: Siloed budgeting runs counter to the goal of a budget rigorously vetting the operational goals of supporting the strategic plan. Marketing, Sales, Product, HR, and Operations all rely on each other’s functions. Cross-team meetings early on with defined agendas and shared assumptions are helpful in this regard.