Management of Costs and Expenses This program is about the “standing” mission of every business entity to be more effi

1. Management of Costs and ExpensesThis program is about the “standing”mission of every business entity to be more efficient! Altaf Noor Ali Chartered Accountant

2. In this segment, we will have a closer look at: Accounting equation. Cash flow. Efficiency and effectiveness. Profit analysis. As facilitator, my mission is to provide a ‘valuable’ experience for you. I will do so by creating an environment conducive to exchange of ideas and learning on the topic. Primer

3. We will start with a basic understanding of how costs expense impact basic accounting equation. The accounting equation is: Assets – liabilities = equity. Equity = investment + profit. Profit = income – expenses. Mr. A starts a business with Rs. 100. He rents a shop for Rs. 5….. Understand how expenses impact the basic accounting equation

4. Let us learn when: Profit = cash flow. Why learning about profits and cash flow is important? What are cash inflows? Is revenue an example of cash inflow? What are cash outflows? An expense is a cash outflow. Profit and cash flow: the difference

5. Efficiency is a relationship between ‘inputs’ and ‘output’. When would consider an operation to be efficient: Inputs = outputs Output < inputs Output > inputs Examples of inputs and outputs: 70,000 litres of petrol 10,000 units of product ‘A’ 200 students ‘Managing costs is about being efficient’.‘Profits’ and ‘efficiency’

6. What is the difference between ‘efficiency’ and ‘effectiveness’? Is operating ‘profit’ a broad financial measure of operational ‘efficiency’ and ‘effectiveness’? We can attribute the element of ‘efficiency’ in operational “profits” by: Comparing profit for the current period with previous period. Inter-company comparison. The measures that bring operational ‘efficiency’ can be taken in the ‘short-term’ whereas ‘effective’ measures require a ‘long-term’ span? ‘Managing costs is about being efficient’.‘Efficiency’ and ‘Effectiveness’

7. Gross Profit = Revenue – Cost of Sales. Illustration by a manufacturing model: refer to the excel sheet Assumptions: Revenue and cost data are accurate. Basic “Gross Profit” analysis…

8. What would be the impact of the following on the profit (and costs)? Economies in purchases result in savings. Hired another manager. “Profits” and “Costs”: the relationship

9. Accounting equation shows impact of business transactions on assets, liabilities and equity. Profit analysis provides a ‘general idea’ of efficiency in financial performance on comparison. Efficiency = doing things right. Effectiveness = doing right things. Measures for improving efficiency is a short-term approach. Measures for improving effectiveness take relatively longer-term. End of Primer

10. This program focuses primarily on the ‘efficiency’ part of managing costs and expenses. Our basic theme is that the traditional accounting system in business entities is devoid of critical info required for management of costs, expenses and charges. Part 1: Costs and Expenses Program Scope

11. Stakeholders; expense cycle and cost drivers. Preferred business strategy in difficult times: enhancing revenue, reducing costs, or both? Costs, expenses and charges: its nature and classification Capital expenditure: why it is critical for business survival? Managing Costs & ExpensesCosts and Expenses in Business

12. A business is about addressing the legitimate needs of its stakeholders. Stakeholders and their stakes Customers = access to offerings and a value proposition for satisfying needs. Suppliers = payment for supplies and services. Employees = career and compensation. Financiers = repayment of loans and interest. Government = taxes Shareholders = capital and share of profits. General public = good conduct and corporate citizenship. Stakeholders

13. Instant: when expense = cash outflow e.g. buying something urgently required on cash. Advance payment: when cash outflow is the head and tail with expense transaction sandwiched in between e.g. paying advance for building a parking shed in factory. Deferred payment: expense followed by payment e.g electricity, telephone Deferred multiple payment to settle the transaction e.g. leasing a delivery truck on no down payment and monthly repay starting three months from its delivery. Ordering an item = consumption? Buying an item = consumption? Expense = consumption? Payment = consumption? Delivery of goods or service = consumption? Issue of goods from store = consumption? Use of material for finished product = consumption? Payment of tax = expense? Payment to employee = expense? Expense Cycle

14. Essentially it is non-financial measures that drive a financial cost. For example, the telephone bill is made up of number of calls made, the kesc bill is dependent on the power consumed, a meal bill is depends on the menu ordered. Cost drivers

15. Outline of basic business strategy Reduce costs Review and examine business model. Define strategy Reduce costs Enhance revenue Product-market matrix Risk evaluation Additional capital Both Signs of difficult times Rising costs because of runaway inflation. High interest rates making bank financing prohibitive for growth. Unavailability of credit for financing growth. Recoveries from customers difficult. Business Strategyin Difficult Times

16. The ceo announces ‘across the board reduction in expenses by a certain percent’. ‘austerity’ drive for top management. No fresh recruitments. Reducing employee perks like overtime. Retrenchments and no-increments. Closing production lines. Disposing business segments. How effective are these strategies? How should it be done? How businesses carry out the cost reduction strategy?

17. Every item of expense requires a different management strategy. There may be certain common elements involved in management of expenses but they cannot be managed adequately on such basis ONLY. Creative Accounting: techniques for concealing expenses: Recognising a revenue expense as a capital expense. Example: building renovation as capital expense. Recognising interest as a part of long term asset. Intangible assets like goodwill etc. Costs, expenses and charges:its nature and classification

18. Suppose you decide to purchase a delivery vehicle of Rs. 2 m for cash. By how much this transaction will impact Your profit, assuming you depreciate delivery van on five year straight line basis. Your cash flows. On what basis should you take such business decision? Would your basis be any different if you were buying a machinery for enhancing your production rather than delivering your product? Should you buy the truck if you know that it will cost you Rs. 60,000 per year on its running and save truck rental of Rs. 180,000 over next 5 years. The sale price of truck is estimated at Rs. 0.5 m at that point. Capital for vehicle is available at 15%. Capital Expenditure: why is it critical for business survival?>

19. The impact of capital expenditure decisions is clear in long-term than short-term. In a way, capex is more about effectiveness than efficiency. Capex is about finding ‘present value’. Wrong capex decision will surely jeopardise a business survival. Capex = buying a long-term asset (plant, computer, vehicle, land, building a facility, an investment, acquiring a business, etc.) >Capital Expenditure: why is it critical for business survival?

20. Cost drivers directly impact cost. Every item of cost will have its own cost driver. Costs comes in many forms. We will use the term ‘expenses’ for costs, expenses, charges. Cap ex is about finding present value of a long-term project. Its more often is directed towards operational effectiveness than efficiency. Capex is a sunk cost and is irrelevant for decisions. End of Part 1

21. In this part we will be understanding business model of a business entity. We will be also looking at what are recurring (routine) and non-recurring (non-routine) expenses and which ones require more scrutiny. We will be proposing that the financial part happens in the end, there is a lot that happens before an expense is incurred. Cost classifications Part 2:

22. Use of non-financial information for understanding costs. Cost drivers Identification Fuel Telephone Electricity Role in expense analysis. What if there is no cost driver for an activity? Basic assumption in cost analysis: Recurring and non-recurring expenditure. What impairs expense analysis? Accounting system limitations. Inherent Chart of Accounts Inaccurate recording. Incompetent accounting staff Non-recording or untimely recording. Inadequate info about past transactions. Non-identification of location, revenue, cost, or expense center. Unrelated to business costs. Understanding business model, financial impact, and cost behaviour

23. Frequently incurred expenses are easier to place and record. They may not be of the same amount. They may not happen exactly at the same time frequency. Non-recurring expenses are kind of one-off and raise the risk of wrong recording and classification. Recurring & Non-recurring expenses

24. Non-financial measures drive the financial transactions. Expenses cannot be analysed properly without the proper understanding of the inputs. A business model can be described in terms of inputs and outputs, in financial and non-financial terms. Non-financial transaction information

25. Identification Role What if there is no single cost driver or is not readily identifiable. Examples include the number of liters for vehicles, photocopies to estimate the photocopy expense, etc. Cost drivers

26. Recurrence Change can be attributable to a change in single variable. The cost of reviewing expenses is greater than the benefit derived from the activity. Large number of transactions relating to expenses than say, revenue. If we take care of the large ticket expenses, the smaller ones should not bother us that much. Time spent on analysing each item of expense should be in proportion to its financial impact. Basic assumptions in cost analysis

27. Basic assumption in cost analysis: Recurring and non-recurring expenditure. What impairs expense analysis? Accounting system limitations. Inherent Chart of Accounts Inaccurate recording. Incompetent accounting staff Non-recording or untimely recording. Inadequate info about past transactions. Non-identification of location, revenue, cost, or expense center. Unrelated to business costs. What impairs cost analysis?

28. We refer to the test now. The next part deals with recording, reporting and monitoring of expenses. End of Part 2

29. Expenditure groups. We will refer to the Star (Pvt) Ltd. and look at what expense reports look like? A run through the excel software for analysing expenses. Part 3: Analysing Expenses

30. Time now to learn about how to go about conducting a practical expense analysis…. Refer to the excel worksheet to see a model analysis of expenses… Excel spreadsheet is the most efficient tool for conducting an initial analysis. We have taken the consolidated financial statements of Engro Chemicals Pakistan Limited at 31-12-08 as an example. Key learning: keep your eyes on big picture; don’t be confused by inventory and non-inventory costs. Conducting cost analysis

31. Major expenditure groups Direct product costs Human resources Utilities Maintaining assets Government levies and charges Grouping expenses makes analysis easier. Analytical review is what it is called. Analysing past expenses

32. After conducting an overall general analysis (we call it level 1 analysis), we will now show you how to ‘categorise’ expenses for a more meaningful analysis…. Refer to the excel worksheet to see a model analysis of expenses… Its unfortunate that financial statements do not provide much by way of explanation to know what was the cause of changes in the expense. Therefore, we may not be able to comment on the cost structure comprehensively. However, we have quantified changes for further analysis. Conducting cost analysis advance

33. Business concerns engaged in services do not largely carry closing inventory, as manufacturing concerns do. Here we will discuss how the accounting rules permit valuation of stock, and carry forward a portion of overheads to the next accounting period. Business concerns engaged in services are not free from accounting complications…. For example, consider an IT concerns ITM who is working on an uncompleted project at the year end 30-6-08. How do you suppose this uncompleted project will be valued? Manufacturing concerns:Valuation of Closing Stock

34. To what extent a traditional accounting system is capable of addressing information needs for cost monitoring? How the compensation systems can be aligned to manage controlled costs? How can we go about implementing measures for the monitoring of costs in our organisations? Guidelines on efficiently concluding a periodical review of expenses. Part 4: Recording and reporting of expenses

35. We started with the analysis to give you an idea about how it is performed. Time now to take a step back and see how expenses are recorded by business concerns. The discussion will be about enhancing the functionality of accounting system by cost recording and reporting. Accurate and prompt recording of vouchers is the first step towards identifying the initiator, user and approver of cost. Monitoring of costs require a system capable of ‘recording and reporting’ costs for each cost center in the form of expense schedule. The accountants should have a proper guideline on how to record a transaction through ‘chart of accounts’. Recording should be done at the earliest and reviewed. How expenses are recorded?

36. The first step towards managing costs is its accurate ‘recording’….and ‘consumption’ (when supplies are routed through stores). In practice, almost in each transaction some of the particulars are not available, or even if they are available these are not recorded accurately. It is natural to think of incurred expense as nothing more than an evidence of payment or having it for recording in accounting system only. Most management see it as a waste of time to go any further than is required as minimum record for “accounting purposes”. It is difficult to see an expense as an ‘exchange’ for cash and the financial information generated in the process as useful for future info needs. Record accurately the following for each transaction: Location Cost center and allocation Initiator (Purchase Requisition) Approver Purchaser (Purchase Order) Store-In: Evidence of delivery at stores Supplier delivery note and or Invoice Payee Content Quantity Rate Amount Tax deduction Date of payment Account code Recording, reporting and monitoring of expenses>

37. An incurred expense is thought of as nothing more than an evidence of payment, necessary solely for recording in accounting system only. Most management see it as a waste of time to go any further than is required as minimum record for “accounting purposes”. Again, this is primarily because of ‘high volume’ of transactions of relatively moderate amounts. As a result, such data is not useful on its own for proper analysis, although some generalised (but not necessarily accurate) conclusions may be drawn from it. Why? Because such data addresses accounting, not analysis needs. It is difficult to see an expense as an ‘exchange’ for cash and the financial information generated in the process as useful for future info needs. >Recording, reporting and monitoring of expenses

38. Human resource compensation: Traditional approach Cash compensation Monthly salary and allowances Bonuses Merit based Increments, based on management evaluation. Arrear payment Deductions Non-cash compensation Vehicle and fuel Phone Medical Group Insurance End of Service Benefits like gratuity, provident fund, etc. Compensate employees on merit and productivity. Sure, these terms mean differently for different nature and position. Compensate employees for cost management and savings made. Such system are difficult to capture and implement, and require investment and dynamic thinking. Aligning Human Resources

39. Our basic assumption is that expenses of recurring nature are the ones that can be analysed most usefully. Recurring expenses are usually high in terms of number of transactions and of moderate amounts. Accounting system are incapable of identifying an expense as recurring or non-recurring. Non-recurring expenses require different approach for its analysis. Recurring expenses

40. Documenting operating system is the most difficult of tasks. How exactly the procedure will take place? What kind of records will be kept at the department and how will it be recorded? How will such item be recorded in the accounting system. Operating Procedures for Recurring Expenses>

41. A company sells milk beverages (say Milkpak or Olpers). It distributes its products in Karachi through a fleet of company owned vehicles. Sometimes it rents vehicles as well. The vehicles are the responsibility of ‘Vehicle Department’. Assume that the costs incurred can be classified as follows: driver salary, fuel, part replacement, maintenance, insurance, taxes parking and bribes, purchase cost of new vehicles, rentals, depreciation, department expenses, unclassified expenses, etc. You have been asked to analyse the costs incurred during the last six months ended 31-12-08. As a cost analyst what is the minimum information you would require? Can you analyse cost If there are no standard operating procedures for the vehicle department? How would you rate the quality of such analysis? If vehicle-wise records are not kept. What do you think would be the reasons for not having such records? What kind of operating procedures and analysis framework would you suggest for the department? >Operating Procedures for Expenses: Group Activity

42. The quality of review depends on how expenses have been recorded in the accounting system. Often the recording is of pathetic standards because of incomplete information available at the time of recording of transaction and lack of review. Accounting systems are normally not geared for expense analysis. For example, a bill may contain fuel and lubricants together for two vehicles but recorded as a single amount in the system. For high value items, a separate system specially designed may be required, in which case reconciliation with financial accounting will be a procedure. Ensuring data integrity and completeness is the most difficult task in such situations. The quality of expense reviews improves significantly with monthly basis. Quarterly reviews are preferable over single yearly reviews, which is certainly better than not having any. Monthly reviews enable errors and gaps in info to be identified and closed at the earliest. Analysing any item of expense involves checking rechecking with source document, tracing, sorting and aligning large number of transactions of similar nature. For example, fuel and lubricants in motor vehicle expenses may be divided into atleast three categories (one category for items not clearly classified). The system should be able to export the data to say spreadsheet package for further analysis and its expression in visual form. Guidelines on efficiently concluding a periodical review of expenses

43. Traditional accounting system are not geared towards monitoring of costs and expenses. Having linked but separate modules should be thought of as a supplement to the accounting system and not a threat to it. Analysis of costs is not possible without proper expense schedules. Refer to test 4… End of Part 4: Recording and reporting of expenses

44. “Operating Budgets” serve as a feed forward control system. However, changing business conditions render budgets outdated. Making use of past financial data can yield realistic budget estimates. In the absence of budgets, the past history can serve as a benchmark for comparing current results, flexed appropriately. Not all capex decisions are capable of present value analysis. What to do in such cases? Part 5: Anticipating expenses and cashflows

45. Financial history of expenses is unfortunately not given the importance it deserves. Extensive review of past expenses helps us understand its behaviour and for using it as a reference for monitoring current costs. Capital expenditure decisions, in practice, may not be readily put to “present value” test. For example, how would you evaluate whether a manager requires a laptop or not. Anticipating expenses and cashflows

46. Why this approach has not been successful? Why are we so reluctant to budget? Unavailability of data Developing alternatives plans and packages Expensive in terms of time and expense. Zero-base budgeting

47. A business needs to take many capital expenditure decisions. Not all decisions are capable of “present value” basis. In such cases, qualitative factors are considered. Decision to hire a highly paid manager is not a capital expenditure decision in any sense, however, the nature of decision is the same. Capital expenditure decisions

48. The exercise of preparing operational budget inculcates a forward looking approach. However give the dynamic environment in which a business exists, plans change and so do budgets. The financial history of an entity can serve as a valuable reference for comparison. End of Part 5: Anticipating expenses and cashflows

49. How much of financial information can be shared with the internal stakeholders? How much training our non-financial managers need to understand financial implications of their operational decisions? Do we need any changes in the organisation structure? How can we involve staff in cost initiatives? Can we have cost teams, similar to the quality teams, responsible for monitoring of costs and controlling them? Part 6: Structure for expense management

50. The traditional view is that it is the responsibility of every one in the organisation to be efficient and curtail cost. A task that’s everybody’s is nobody’s. Or, this is what the accountants are trained for, it’s their baby. Why not make the Accounting Department responsible for the cost analysis when they have all the source documents and data used for such reviews? Can Accounting Department conduct such reviews on its own? What would be its quality? How about internal auditors? Or, external auditors who do something called ‘analytical review’? Managing costs and Management structure