Cost Management 20%

Benefits and limitations of absorption and V. costing

 Absorption costing is required by both the U.S. Internal Revenue Service and GAAP.
 However, absorption costing does enable managers to manipulate operating income simply
by increasing production or by producing items that absorb the highest fixed manufacturing
costs.
 Variable costing is used when the emphasis is on what items can be traced to and
controlled by a responsibility center. The method is very effective in supporting internal
decision making and is required for cost-volume-profit analysis.

Benefits and limitations of ABC

Benefits
 ABC reduces distortions found in traditional cost allocation methods that allocate overhead by
department.
 ABC measures activity-driving costs, allowing management to alter product designs and
activity designs and know how overall cost and value are affected.
 ABC normally results in substantially greater unit costs for low-volume products than is
reported by traditional product costing.

Limitations
 Not all overhead costs can be related to a particular cost driver and may need to be arbitrarily
allocated.
 ABC requires substantial development and maintenance time, even with available software.
 ABC, if viewed only as an accounting initiative, will likely fail.
 ABC generates vast amounts of information. Too much information can mislead managers into
concentrating on the wrong data.
 ABC reports do not conform to GAAP, so restating financial data adds an expense and causes
confusion.
Benefits and limitations of process costing
Weighted average method versus the first-in, first-out method:

 The weighted average method is easier to use as the calculations are simpler. This method
tends to obscure current period costs as the cost per equivalent unit includes both current
costs and prior costs that were in the beginning inventory. This method is most appropriate
when conversion costs, inventory levels, and raw material prices are stable.
 The first-in, first-out method is based on the work done in the current period only. This
method is most appropriate when conversion costs, inventory levels, or raw material prices
fluctuate. In addition, this method should be used when accuracy in current equivalent unit
costs is important or when a standard cost system is used.

Master production schedule

Definition In MRP, a master production schedule dictates the quantities and timing of each part
to be produced.

Advantages The advantages of this system include predictability and efficient inventory
control.

Disadvantages The disadvantage is potential inventory accumulation; workstation may receive

materials before they are ready to process them.

Advantages and limitations of JIT systems

Advantages
 No overproduction, so no resources are tied up in inventory and inventory management.
 Reduced set-up and lead time production priorities build into system.
 Faster feedback for quality control; items do not sit in warehouse, so problems spotted
sooner.
 Simplified ordering, built into production process.
 Strong supplier relationships, based on sustained business instead of competitive rebidding.

Limitations
 No buffer inventory; production may wait.
 Potential for overtime, added costs to fill unexpected orders.
 Heavily dependent on reliability of every supplier in supply chain.
 Potential stock out at a supplier can shut down entire line.
Theory of Constraints
 Throughput contribution = Sales revenue – Direct material costs.
 Inventory = (Materials costs in direct materials, Work-in-process, and Finished
goods inventories) + (R & D costs) + (Costs of equipment and buildings).
 Operating expenses = All costs of operations, not including direct materials.

Value Chain Analysis

Value chain
 A system of interdependent activities, each intended to add value to the final product or
service.

Supply chain
 The extended network of distributors, transporters, storage facilities, and suppliers that
participate in the production, design, sale, delivery, and use of a company’s product or
service.

Steps in value chain analysis

 Step 1 (internal cost analysis)
 Step 2 (internal differentiation analysis)
 Step 3 (vertical linkage analysis)

Note: In the quality profession, a customer is anyone who is impacted by an organization’s

processes, products, and services. A firm has both internal and external customers.

Process analysis characteristics

 Effectiveness
 Efficiency
 Adaptability
 Process reengineering
 Business process reengineering (BPR)
Discuss cost of quality
Conformance costs
The costs of conformance are the costs that the company incurs to assess internal quality
with the purpose of insuring that no defective products reach the customer. The two types of
costs of conformance are:

1. Prevention costs are the costs that are incurred in order to prevent a defect from
occurring in the first place. Prevention costs include:
 Quality training and planning costs.
 Equipment maintenance costs.
 Supplier training and confirmation costs.
 Information system costs.
2. Appraisal costs are the costs that are incurred in order to determine if an individual unit
is defective. These are the costs of:
 Testing and inspection.
 Quality audits.
 Internal quality programs.

Non-Conformance costs
Nonconformance costs are those costs that are incurred after a defective product has already
been produced. It can be broken down into two types:

1. Internal failure occurs when we detect the problem before shipment to the customer.
The costs associated with this are:
 Rework.
 Scrap.
 Tooling changes and the downtime required to do the tooling changes to correct a defective
product.
 Expediting costs – the cost of rushing to re-perform and complete an order in time because of
a failure to complete it correctly the first time.
2. External failure occurs when we do not detect the defect until the product is already
with the consumer. The costs of this are:
 Warranty costs.
 Product liability costs.
 The loss of customer goodwill.
 Environmental costs.
Advantages and Disadvantages of ABM
Advantages
 Uses continuous improvement to maintain the firm’s competitive advantages.
 Allocates more resources to activities, products, and customers that add more value,
strategically redirecting management focus.
 Eliminates non-value-added activities.
 Measures process effectiveness and identify areas to reduce costs or increase customer value.
 Works well with just-in-time processes.
 Ties performance measurement to ABC to provide consistent incentives for using ABC.

Disadvantages
 Produces different pricing, process design, manufacturing technology, and product design
decisions.
 Cannot be used for external financial reporting. Reports must also be prepared using
traditional methods.
 Is costly and time-consuming to implement.
 Requires users to change their methods of operation and analysis.

External Financial Reporting 15%

Limitations of financial statements in general
 Measurements are made in terms of money, so qualitative aspects of a firm are not included.
 Information supplied by financial reporting involves estimation, classification, summarization,
judgment, and allocation.
 Financial statements are based on historical cost.
 Only transactions involving an entity being reported upon are reflected in that entity’s
financial reports. However, transactions of other entities such as competitors may be very
important.
 Financial statements are based on the going-concern assumption. If that assumption is invalid
and the business is facing liquidation, the appropriate attribute for measuring financial
statement items is liquidation value. It is not historical cost, fair value, net realizable value, or
any other valuation measure used for a going-concern’s financial statements.
Planning, Budgeting & Forecasting 30%
Benefits and Limitations of Regression Analysis
Benefits:
 Regression analysis is a quantitative method and as such, it is objective.
 Thus, regression analysis is an important tool for use in budgeting and cost accounting.

Limitations:
 If historical data is not available, regression analysis cannot be used.
 If there has been a significant change in the conditions surrounding that data, its use is
questionable for predicting the future.
 If the choice of independent variable(s) is inappropriate, the results can be misleading.
 The statistical relationships that can be developed using regression analysis are valid only for
the range of data in the sample.

Benefits and Limitations of Learning Curve Analysis

Benefits:
Decisions such as the following can be aided by LC analysis:

 Make or buy decisions. Life-Cycle costing.

 Cost-Volume-Profit analysis. Development of standard costs.
 Capital budgeting. Management control.
 Development of production plans and labor requirements.

Limitations:
 LC analysis is appropriate only for labor-intensive operations involving repetitive tasks where
repeated trials improve performance.
 The learning rate is assumed to be constant. In real life, the decline in labor time might not be
so constant.
 The reliability of a learning curve calculation can be jeopardized because an observed change
in productivity might actually be associated with factors other than learning. An increase in
productivity might be due to a change in the labor mix, a change in the product mix or other
factors. If that is the situation, a learning model developed using this historical data would
produce inaccurate estimates of labor time and cost.
Budgetary Slack
Definition:
 Budgetary slack is the difference between the budgeted performance and the performance
that is actually expected. It is the practice of under estimating budgeted revenues and
overestimating budgeted costs to make the overall budgeted profit more achievable.

Advantages:
 It can provide managers with a cushion against unforeseen circumstances. This can limit their
exposure to uncertainty and reduce their risk aversion.

Disadvantages:
 It misrepresents the true profit potential of the company and can lead to inefficient resource
allocation and poor coordination of activities within the company.

A Budget Manual
 Describe how a budget is to be prepared. Include a budget planning calendar and distribution
instructions for all budget schedules.

Budget Planning Calendar

 Is the schedule of activities for the development and adoption the budget, it includes a list of
dates indicating when specific information is to be providing to other.

Steps in the strategic management process

1. The board of directors drafts the organization’s mission statement.
2. The organization performs a situational analysis, also called a SWOT analysis.
3. Based on the results of the situational analysis, upper management develops a group of
strategies describing how the mission will be achieved.
4. Strategic plans are implemented through the execution of component plans at each level of
the entity.
5. Strategic controls and feedback are used to monitor progress, isolate problems, and take
corrective action. Over the long term, feedback is the basis for adjusting the original mission
and objectives.
Situation analysis
SWOT Analysis
 External factors. Recognition of organizational opportunities, limitations and threats.
 Internal factors. Recognition of organizational strengths, weaknesses and competitive
advantages.

Porter’s five competitive forces

1. Bargaining power of suppliers.
2. Bargaining power of customers.
3. Threats of new entry.
4. Threats of substitutes.
5. Intensity of rivalry among established firms.

Strategies with a broad competitive scope (cost leadership and differentiation)

Strategies with a narrow competitive scope (cost focus and focused differentiation)

The 5C analysis
1. Company.
2. Competitors.
3. Customers.
4. Collaborators.
5. Business climate.

Pest analysis
1. Political factors.
2. Economic factors.
3. Social factors.
4. Technological factors.

Boston consulting group BCG matrix

1. A star (industry has a high market growth rate, and the product has a high market share)
2. A question mark (industry has a high market growth rate, and the product has a low market
share)
3. A cash cow (industry has a low market growth rate, and the product has a high market share)
4. A dog (industry has a low market growth rate, and the product has a low market share)
Comparison of strategic and operational plans
Strategic plan
Focus Underlies both long- and short-run planning; provides the basis for the budget.

Issues Examined Identifies and analyzes issues such as:

 New global market entrants, economic conditions & plans for diversification.

Development Flows from top down.

Control Reviewed annually.

Operational plan
Focus Formulates specific goals for each business with detailed revenue and expense budgets.

Issues Examined Identifies and analyzes issues such as:

 Quarterly earnings, inventory levels, major capital expenditures, marketing plans and
productions plans.

Development Flows from bottom up.

Control Reviewed and updated/modified periodically throughout the year.

The budget cycle

A budget cycle usually involves the following steps:

1. A budget is created that addresses the entity as a whole as well as its subunits, and all
managers agree to fulfill their part of budget.
2. The budget is used to test current performance against expectations.
3. Variations from the plan are examined, and corrective actions are taken when possible.
4. Feedback is collected, and the plan is revisited and revised if needed.

Reasons for budget

1. Planning.
2. Control.
3. Motivation.
4. Communication.
5. Evaluation.
Benefits and Limitations of strategic planning
Benefits
1. A systematic approach to analyzing threats and opportunities and examining why some
organizational strategies have better competitive and profit prospects than others.
2. A sound framework for developing an effective operating budget.
3. An organizational learning opportunity for managers to think about strategies and how to
best implement them.
4. An exercise to align management decision making and actions with corporate strategies.
5. A basis for both financial and nonfinancial performance measures.
6. A channel of communication among all levels of management about strategies, objectives,
operational plans, and so on.
7. Guidance for approaching new situations.

Limitations
1. The effort, time, and expense involved in the process.
2. The fact that planning based on predictions is not an exact science.
3. The potential for resistance to change resulting from entrenched ways of doing things.
4. The risk that planning can become a bureaucratic exercise devoid of fresh ideas and strategic
thinking.

Characteristic of successful budget

Many factors characterize a successful budget, but no single factor can lead to a successful
budget. The common factors in a successful budget include the following:

1. The budget must be aligned with the corporate strategy.

2. The budget process should be kept separate.
3. The budget should be used to alleviate potential bottlenecks.
4. The budget must contain technically correct and reasonably accurate numbers and facts.
5. Management must fully endorse the budget.
6. The budget must be perceived by employees as a planning, communication, and coordinating
tool, and not as a pressure or blame device.
7. The budget must be characterized as a motivating tool.
8. The budget must be seen as an internal control device.
9. Sales and administrative budgets need to be detailed in order that key assumptions can be
better understood.
Discuss budget process
Comparison of authoritative, combined, and participative budgeting:

Authoritative Approach
 Top management incorporates strategic goals into their budgets.
 Better control over decisions.
 Dictates instead of communicates.
 Employees: Resentful and unmotivated
 Stringent budgets may not be strictly followed at lower levels.
 Not a recommended approach but could work in small or slow-changing environments.

Combination Approach
 Strategic goals are communicated top-down and implemented bottom-up.
 Control retained and expertise gained at cost of a slightly longer process.
 Two-way communication: top-management understands participants’ difficulties and needs.
Participants understand management’s dilemmas.
 Personal control leads to acceptance, which leads to greater personal commitment.
 Ownership of budget and through review leads to tight budgets that get followed.
 Best for most companies; provides balance between strategic inputs.

Participative Approach
 Strategic goals do not receive priority in the budgetary process.
 Expertise leads to informed budget decisions.
 Communicates lower-level perspective to management.
 Employees: Involved and empowered.
 Easy or abdicated approval can lead to loose budgets and budget slack.
 Best for responsibility centers with highly variable situations where area manager has best
data.

Internal and external factors affecting strategy

Internal factors: Resources, skills and processes.

External factors: Legal and regulatory factors, market forces, industry trends, competition,
technological changes, stakeholder groups and their social concerns, globalization trends, emerging
markets, and nongovernment organizations.
Performance Management 20%
Transfer pricing
Definition:
 Allocating costs to a responsibility center or segment involves assigning pricing for the goods
and services that pass between segments. Transfer pricing sets prices for internally exchanged
goods and services.

Methods:
1. Market price
Advantages: Easy to maintain and document; preferred method.
Disadvantages: Focus on external customers could affect purchasing segment.

2. Negotiated
Advantages: Could help company as a whole.
Disadvantages: Non-market based prices are subject to greater tax scrutiny by tax authorities.

3. Full cost
Advantages: Provides purchasing segment with an established price.
Disadvantages: Tax scrutiny; seller has no incentive to control costs.

4. Variable cost
Advantages: Helps the selling segment if it has excess capacity.
Disadvantages: Tax scrutiny; seller has no incentive to control variable costs.

Usage & Goals:

Motivation is the desire of managers to attain a specific goal and the commitment to accomplish the
goal. Motivation is therefore a combination of goal congruence and managerial effort.

Goal congruence takes place when a manager’s individual goals align with those of the organization.

Managerial effort is the extent to which a manager attempts to accomplish a goal.

Note: Transfer prices are used by profit and investment centers.

Note: Transfer pricing now used for tax shirk by multinational companies.
Balanced Scorecard
Companies use the BSC as a management tool to:
1. Clarify and communicate strategy.
2. Align individual and unit goals to strategy.
3. Link strategy to the budgeting process.
4. Get feedback for continuous strategy improvement.

Effective use of a balanced scorecard:-

1. Cause-and-effect relationships.
2. Outcome measures and performance drivers.
3. Links to financial measures.

Continuous improvement cycle consisting of five steps:

1. Translate the strategy in operational terms.
2. Align the organization to the firm’s strategy.
3. Make strategy everybody’s everyday job.
4. Make strategy a continual process.
5. Mobilize change through executive leadership.

Critical success factors (CSF) or Key performance indicators (KPI)

Financial measures:

 Return on investment (ROI) and Residual income (RI).

Non-financial measures:

1. Customer outcome measures:

 Customer profitability, Customer retention, Customer acquisition, Customer satisfaction and
Market share.

2. Internal business process measures:

 Operations, innovations and Post-sale service.

3. Learning and growth measures:

 Employee skill, information system capabilities, empowerment, motivation and organizational
alignment.
ROI vs. RI
When ROI is used as a primary performance evaluation tool, managers of business units with higher
profits according to ROI may reject capital investments that do not promise as good or better an ROI
than the rate being currently earned – even if the investment is strategically beneficial to the
organization as a whole.

RI gives managers the incentive to select any project that generates returns above the required rate
of return. Because RI is measured in terms of absolute dollar amounts (and not in percentage
amounts)

ROA (ROI) = Net Income (Operating Income)/Average Assets (Capital Investment) = ...%
Average Assets = Beg + End / 2

Capital Investment = (LTL + Equity) or (WC + FA) WC = CA – CL

RI = Operating Income – (Imputed Interest * Capital Investment)

Du-Pont
ROA (I) = NI/A = NI/S (Profit Margin)* S/A (Assets Turnover)

ROE = NI/E = NI/S (Profit Margin) * S/A (Assets Turnover) * A/E (Financial Leverage or Equity
Multiplier)

Internal Controls 15%

Objective of internal control (According to AICPA)
 Provide reasonable assurance (not absolute) regarding the achievement of the
objectives in the following categories (SCARE):-

1. Safeguarding of asset.

2. Compliance with applicable laws and regulations.

3. Accomplishment of organizational goals and objectives.

4. Reliability of financial reporting.

5. Effectiveness and efficiency of the operations.

Component of internal controls under COSO model
COSO = Committee of sponsoring organization model 1992

Control environment. (Set the tone)

1. Organizational structure
 incomputable duties (execute, record, custody, and reconciliation)
 Independent check (unconnected & without custody)
2. Personal policies.
 Hiring, training, & promotion standards
 Commitment to competence
3. Policies. (Require or restrict or guide actions)
4. Procedures. (Details steps)
5. Objectives & goals. (realistic & achievable)
6. Management philosophy. (attitude toward risk)
7. Integrity & ethical value. (people who design and implement controls)
8. Assignment of authority. (line of reporting)
9. BOD participation & audit committee participation.

Risk assessment. (Identify & analysis)

Control activities.
 Types of control (Preventive, Detective, Directive, Corrective, & compensating)
 The COSO model lists six control activities:-
1. The assignment of authority and responsibility (job descriptions)
2. A system of transaction authorizations
3. Adequate documentation and records
4. Security of assets
5. Independent verification
6. Adequate segregation of duties (execute, recording, custody, and periodic reconciliation)

Information & communication systems. (Capture & exchange)

Monitoring. (Assess the quality)

Inherent limitation of internal controls
1. Cost & benefit (cost of controls should not exceed the benefit of it).
2. Collusion among individuals.
3. Management override.
4. Misunderstanding of instructions.
5. Mistake of judgment.
6. Personal carelessness.
7. Staff & size limitation.
8. Integrity & ethical value (of people who design, implement and monitor controls).

Legal aspects of internal control

Foreign corrupt practices act (FCPA) in 1977

All Public companies

1. Make & keep books and records.
2. Advise & maintain system of internal accounting control to provide reasonable
assurance that:-
 Transactions are executed in accordance with management authorization.
 Transactions are recorded to permit preparation of financial statement under GAAP or any
applicable criteria.
 Access to asset is permitted only with management authorization.
 Periodic reconciliation for asset at reasonable intervals.

Sarbanes Oxley act (SOX) in 2002

Publicly traded securities

1. Audit committee be independent.
2. Issue a report stated that:-
 Management responsibility for internal control.
 Management assessment of effectiveness of internal control.
 Identification of frame work used to evaluate the effectiveness.
 External auditor has issued attestation report on management assessment.
The audit risk model
Risk (TR) = IR x CR x DR:-
1. Inherent risk (IR) is the susceptibility of one of the company's objectives to obstacles
arising from the nature of the objective.
2. Control risk (CR) is the risk that the controls put in place will fail to prevent an obstacle
from interfering with the achievement of the objective. For example, a policy requiring two
approvals for expenditures over a certain dollar amount could be bypassed by collusion.
3. Detection risk (DR) DR acknowledges that auditor may not detect material
misstatement. Auditor may not properly plan audit procedures (substantive tests) .DR is
within control of auditor .Auditors assess inherent and control risk, and restrict detection
risk.

Discuss PCAOB Auditing Standard No 5 (2007)

 Require auditors to follow risk based approach to the development of auditing
procedures.
 Auditors also required to scale the audit to the size of the organization.
 Require the external auditor to express an opinion on both the system of internal
control and the fairness presentation of financial statements.
 Focus on the existence of material weaknesses in the internal control, which may exist
even financial statement are not materially misstated.

The IIA standards for internal auditors

1. Attribute standards
a- Purpose, authority & responsibility.
b- Independence & objectivity.
c- Proficiency & due professional care.
d- Quality assurance & improvement program.
2. Performance standards
a- Managing the IAA.
b- Engagement planning.
c- Performing the engagement.
d- Communicating results.
e- Monitoring process.
3. Implementation standards
Types of audit conducted by internal auditors

1. Financial audit
 Is an audit of the firm’s financial statements (similar to work performed by external auditor)
 The direction of a financial audit conducted by internal auditors is forward looking in contrast
to the external audit which is backward looking.
 Forward looking: - because the internal auditor assess the adequacy of internal controls as
they relate to financial activities.
2. Operational audit
 Internal auditors have concentrated more on operational audit (over half of the average
internal auditors time)
 Is the comprehensive review of varied functions within an enterprise to appraise the (3E)
economy, efficiency & effectiveness of operations to determine the extent to which
organizational objectives have been achieved?
 It is an organized search for improvement in efficiency and effectiveness of the operation and
often takes on the form of constructive criticism.
 It is a tool for regularly and systematically appraising the effectiveness of the firm against
organizational and industry standards, organizational goals and applicable laws and
regulations (it is a benchmarking activity)
 The auditor has the responsibility of discovering operational problems and recommend
realistic course for resolving the problem.
 The basic tools of internal auditors for operational auditing include:-
a- Financial analysis.
b- Observation of department activities.
c- Questionaries’ interviews of department employees.
3. Compliance audit
 It is a review of both financial and operating controls to see how well they conform to laws,
regulations, standards and procedures.
 It can be a part of financial or operational or undertaken separately.
4. Performance audit
5. Electronic data processing audit
6. Contract audit
7. Special investigations audit (such as fraud)
Risk associated with information system
 There is less visibility of the audit trial.
 Hardware or software may malfunction.
 Reduce human intervention to identify mistakes that software may not design to catch it as a
result systematic error may occur because of flaws in the program design.
 Unauthorized users may accidentally alter or delete data.
 Data may be lost or stolen.
 System may be damage by malicious code.
 Segregation of duties (used as control tool) may be reduced.
 There may be lack of traditional authorization when transactions are initiated automatically.

Business continuity planning

Business continuity planning (BCP) is a strategy that looks to:-

1. Identify an organization’s exposure to internal and external threats.

2. Bring together critical resources and assets in order to protect those resources.
3. Ensure continuing operations and recovery, in the event of an adverse event or disaster.

As part of the BCP process, a business continuance plan is developed, which provides for the
implementation of key control policies and procedures:

1. Data backup policies and procedures.

2. Disaster recovery policies and procedures (business continuance planning)

Three ways deal with BCP

1. Hot site.
2. Cold site.
3. Worm Site.

Fraud & Error

Fraud is intentional and relate to integrity of the organization’s personnel.
It involve:-

1. Pressure or incentive to engage in wrongdoing and

2. A perceived authority to do so

Error is unintentional and relate to the competence of the organization’s personnel.

Application Control
1. Input controls

 Manual
a- Batch controls
b- Approval mechanism
c- Supervisor procedures
d- Dual observation
 Electronic
a- Interactive edit
b- Redundant data check
c- Master file check
d- Anticipated check
e- Preformatted screens

2. Processing controls

 Zero balance check

 Completeness
 Sequence check
 Run to run control totals
 Arithmetic controls
 Key integrity

3. Output controls

 Reports about complete & accurate processing

 Reports about distribution of output
 Error lists reports

4. Storage controls

 Dual write routine