Martin Zralý: COST CONTROL

1. Martin Zralý:COST CONTROL Department of Enterprise Management and Economics Faculty of Mechanical Engineering, Czech Technical University in Prague martin.zraly@fs.cvut.cz Prague 11/2010

2. What is it about ? • Subjects of Cost Control • Information areas linked with Cost Control • Budgeting - principal notes + relationships • Costing - principal notes + relationships + recent development • Hour Cost Tariffs (HCT) Method principal notes + applications • Example: Application of Contribution Margin + HCT-Method in Costing structure • Final Conclusions to Cost Control

3. Subjects of Cost Control What are the basic subjects (entities), to which the costs are linked? • Products(incl. services)(set of products, product’s group) • Processes: productive + supportive • Activities(= as parts of processes or autonomous ones) • Projects • Resources: • Human • Tangible and Intangible • Finance • Departments(Centres)  All of then join technical and financial features in mutual interaction

4. Information areas (agenda) directly linked with Cost • Budgeting, namelyOperating budgeting • Costing • Accounting, namely Internal Accounting (on entities) • Financial and Investment Calculations • Operative recording (non-financial measures): time, capacity utilization, quantity, …

5. Basic practical principles of the Oper-budget application1/2 Budget is primarily about Activities and Processes !!: Figures of Costs + Revenues are only the consequence (BUT important!) of the decision which Activities to do and in which wayActivities (processes) to do  • Budget = a trivial matter ?? • It is about, what I (= manager) do. Do I know it? YES?  Then: No problem to create the budget !   The budget creatingput the questions, which are useful (needed) for deeper understanding of Activities within the department or process: • Do I know, what is the utility of it ?  Revenues (Incomes) • Do I know, how much does it cost ?  Costs (Expenditures) + Summary the ANSWERS.

6. 2/2 • Budget = complex matter. It concerns on: • Content and providing of Activities and Processes and their measurement (indicators has to be determined) • Needed resources: Workers (staff), machines, equipment, software, … • Costs and Revenues • Future (half a year, one year, two or more years), Close future = rest of the period (Expected Actual) and Actual • Budget = Important element of Enterprise control • see previous point • Budget is also about to establish positive and stable conditions for activities (rules, standards, agreements, …) • Budget is also about to searching of the most suitable way, how to provide activities (worker’s skill + training + equipment, activities outsourcing or license, …)

7. Costs and Revenues are only Consequences of Activities and Processes applied • After the targets are given and the set of activities is quite obvious, Costs + Revenues (C + R) can be determined • Also on the contrary: According to targeted size of C + R the changes (or alternatives) of the activities are made (searched)  Feedback (feedback cycle) • C + R are the consequence of the decision-making about the way of activities providing: Purchase, by own means, outsourcing, way of financing, …and other agreements conditions • C + Rare the significant result ofActivities selection – they link technical and economic process point of view !!!(Do we fix C + R ?? WE has to try it again and again)(see also: Manager’s responsibility)

8. Oper-Budget and Activity Based Management (ABM)1/2 ABM = natural conclusion to managerial philosophy based on Activity as principal building item in Management Control: • To two basic lines of Enterprise control (Products + Departments) is added the third: = Activities • Activities are, whatproduce (or support producing) products (and revenues), what isdone in the departmentsand whatconsume costs • That's why: ACTIVITIES (PROCESSES) has to be controlled • Problem: By detailed decomposition into Activities, they are hundreds, but rather thousands  Laboriousness (to plan, to record, to evaluate them!!) How effective the result is? • Recommendation: To apply Methodology Activities Set for Product Sets (AS/PS)

9. The Entities priority in Enterprise Control is changing: 2/2 • Products are primary • Towards Productsthe Processes, resp. Activities are considered:  • ?Which Activities (A) (Processes (P)) are needed (necessary) ? • ? In which scope ?? How to do them (own or purchased)?etc. • Departments (org. structure) has to be tailored to both previous it tends to flexible org. structure, to flexible modification to A + P • The Role of Activities in Enterprise Control Entities: • Activities:mostly a part of other Entity (process, dptm., functional area) BUT also an autonomous entity • Processes= relevant and chronological sequence of activities, mostly targeted to some partial or final product • Products:are developed due to activities (processes) • Set of Activities= targeted grouping of Activities for specific Set of Products • Departments= organizational systemization (arrangement) of Resources and Activities • Functional areas(product development, production, purchase, etc.): are realized by Activities

10. Oper-budget creation1/2 • Budget is about Activities and Processes then it has to be of a different form in each Enterprise and created in an different way(and evaluated in another way) • Budget creation: Long-term and multi-circle process.WHY? • Is linked to the Strategy (e.g. by BSC), particularly to the perspective of Internal processes  Objectives + Targets + Process conditions • In large companies: 1. version of annual budget is get ready at the end of 3/201x • Creation is an continuous process: The essential factors are respected • Systematic, no one step process • To respect essential budgetary factors needs time for balancing and argued • It offers time to ensure external partnerships (services, parts, …) • Importance of existence the plan in technical units(pcs, hours, m3, GJ) • The starting point for budget creationis mostly the agreedannual business plan

11. 2/2 • Consensus on Budget is required • Cooperation of all staff is necessary • Preparation of agreements on services, deliveries, …is a part of budget creation process.It is necessary for credibility and stability of the budget • Budget 1.step: Balancing of internal services + tariffs • Budget = Basic part of Enterprise motivation system • To set up correctly the consolidation rules • Breakdown into months is necessary(it affect to higher accuracy, it is needed due to monthly evaluation, relationships to Cash-Flow, Costing, …) • Necessity of budget creation procedure description(steps, time schedule, responsibility, …)

12. Oper-budget Evaluation • Regularly and a consistently (monthly) - in advanced stated date • Managers monitors the budget sizecontinuously during the whole month • Superior manager has to take a part in evaluation( Decisions are made immediately) • The values of current period and cumulated values are evaluated • Application of Expected Actual Value (EAV)(forecast) • Necessity: To have on disposal supportive recordings(time, capacity, …consumption) and other information • Expected future difficulties are considered, too • Result of evaluation: • Budget confirmation or decisions making about changes (in activities, figures)  EAV

13. Expected Actual Values and Overhead Tariffs • Expected Actual Values • = Tool for updating budget (fitting it to contemporary situation) • = Actual value up to this time point + (possibly) update for the rest of period (year) • Rules has to be accepted for EAV application (Budget updating) • Purpose:To control under real (not fictive) conditions and targets • Cost Tariffs (of the centres, activities, …) • They appreciates cost level of activities, processes, … • The link the cost to capacity !!! • The significance is growing, because the price of resources capacity is growing(of equipment, staff, …) • Application for activities evaluation and appreciation (motivation) • Hour Cost Tariffs (HCT) Method • The controlling evaluation of decisive factors influence is on disposal

14. Why the Head Manager has to be responsible for the Budget ? • Because the Budget is about Activities and Processes  : • Who else should be responsible for Activities and Processes and their development ? • Budget is linked with the resources utilization, i.e. with: • Staff (workers) (number of them, their activities, skills, salaries) • Equipment (machines, tools, …) • Process conditions • Consumed services • Cooperation internal + external • Because the Budget is about Technical and Financial aspects(Costs + Returns)of processes (activities)

15. Decalogue of budgeting practice1/2 • Budget is firstlyabout Activities and Processes and then subsequently about C + R • Budget is something like the Company Low • Budget is the control tool of primary importance for all levels of enterprise control hierarchy (from top to down) • Enterprise (master) budget = linked set of budgets • Budget creation = define contents and conditions of activities for the next period • Budget creation = Long-term and multi-circle process: Enough time is necessary for carefully budget preparation

16. 2/2 • Budget evaluation: Regularly and a consistently • Required:To apply the Expected Actual Values technique • Close relationships to the other information sets in enterprise (Accounting, Costing, Technical recordings (mostly to hour-recordings (!!)), Investment and Financial calculations, and to other control tools (BSC, ABM, Process control, Target costing, …) • Required: Existence and a regular updating of standards linked with budget procedures (budget standards)

17. Costing1/10 • Costing = To allocatein an acceptable way the cost to the cost driver in: • production process • sales process • development process • …… • in an acceptable way ?? • accurate is not achievable, BUT mostly it can be done in an acceptable way (accurate: only for direct cost !!)acceptable = trustworthy for managerial use • cost driver?? • one piece or multiplying of pieces • production order • particular activity • business case (order) • … …

18. Costing2/10 • Costing - what are key factors? • cost(cost identification, type of cost: direct, indirect, fixed, variable, …) • cost drivers (identification, which one or which structure of them is used) • allocation / no allocation to cost drivers     or partial allocation  Absorption Costing x Variable costing • capacity (of process, resources, …)utilization • revenues (expected, planned) as starting point for calculation( variable costing) • What kind of Costing - (time point of view)? • planned (pre-costing) • operational costing • actual (final) costing • proposal costing (for submit an offer for order) • Target Costing

19. Costing 3/10 • Costing - approaches: • Absorption Costing • Variable Costing • Costing - methods and techniques: • Hour cost tariff (HCT) method • Surcharge Costing (= additional cost charges according selected cost driver) • Standard Costing • Activity Based Costing • ….. In practice: combination of different methods and techniques

20. Costing 4/10 • Planned Costing (pre-costing):WHY? • For each product or even a its innovation or changeshas to becalculated its costs in advanceand make comparison with potential price • resp.To design product in such a way, that its total costs will be lower then in advance given COST TARGET (Target Costing), i.e. product will bring required size of CM, resp. size of profit • If TARGET is not kept, the product has to be redesignedwith respect to the COST TARGET (cost limit). Otherwise not start the production! • Final (actual) Costing:WHY? • It normally do not influence the agreed price, BUT it is necessarily for: • Assessment of size and METHODOLOGY of planned (PL) Costing (learning) • Reward/not reward due to keeping/not keeping PL-Costing.

21. Costing 5/10 • Topical (and most frequent) are application of: • Hour Cost Tariff (HCT) Method • Variable Costing (Contribution Margin application) • mostly in interrelated applications. • Application of Variable Costing(Contribution Margin (CM)) (usually Multi-level Contribution margin alternative (3-10) levels) - see Model-3P • By creating of aggregate annual plan (total CM) • By product (service) costing (total or per unit) • By business orders (total and per unit) • In assessment of salesman (instead or together with return) • In assessment of heads of dptm. • In assessment of customers • ….

22. Costing 6/10 • HCT-Method applications are in particular contributive in areas as: • All kind of services • Technical activities and dptms. (Development, Project, Pre-production, Programming, etc.) • Production activities and dptms. (if more expensive even for workplaces) • Post-production activities and dptms. (Packaging, dispatching, etc.) • Assessment of cooperation and make / buy projects assessment. • Reason: It interrelated time costs with time expression of resource capacity!! +seeIntegrative ability and integrative consequences of HCT-Method

23. Hour Cost Tariffs (HCT, HOT) Method1/3 • HCT-Method: Cost-Capacity assessment of the entity Product costing (incl. services) Motivation rewards • Entity (subject) on which the HCT can be applied: • Department or center • Workplace • Machine or Equipment • Activity ( Activity Based Management) • Process ( Process Control) • Worker (research, technician, office, manual, …) • Indirect cost: ICHCT= i=1..n (HCTi ti ) • Total product cost: TC = DC + ICHCT

24. HCT Method - Method’s Alternatives2/3 (1) Basic: • HCT(one value)for entity (subject)(centre, workplace, activity, process, …) (2) Items: • HOT is itemized into more partial Cost-items Examples: • Depreciations (leasing-payments), Personal-costs, Material-costs, Costs of maintenance, Space-costs, Costs of energy, Other costs • Purpose of the itemizing: To gain information about the size and development of the partial cost items (3) Vertical (hierarchical): • HOT is itemized according to vertical enterprise structure Example:Workplace (machine) - Centre (4) Controlling: • The factors causes difference HCTAC - HCTPL are determined • Purpose:To trace the influence of factors on the HCT difference

25. HCT Method - purpose and application3/3 • WHY to apply?? • It includes TIME (capacity in time expression, time consumed by …) • It links budgets of IC + Capacity plan(in mutual interaction) • Reasonably stated hour cost of resources (machines, workers) for expected capacity utilization • Indirect Cost (IC), which are mostly time costs, allocate toproduct according to the cost consumption(NOT according to the Direct Cost!!!) • Easy and trustworthy cost calculation /product by changes of parameters of product or process (e.g.: purchase of new machine) • Easy alternative planned calculations for different capacity utilization • For motivation rewardexecutives + staff • Direct link with Activities ( Activity Based Management) E.g.:Offer very accurate calculation for insourcingoroutsourcingof Activities, for cooperation calculations • Direct link with Processes( Process management) • It is simple, it works with commonly used data • + ……...

26. Example:Application of Contribution Margin + HCT-Method in Costing structure: Price simulation + Target Costing application (TC) + Price (Revenues)(utility features, brand, competitive situation, ...) - Profit - Sales margin - CM / (for) common overhead(exec.,admin., marketing,IT network, …) = Production + Pre-production + Post-production Costs (Direct + Indirect) - CM / product development(HCT)(contribution margin to dptm-cost) - CM / techn. preparation of production, incl. tools, prototypes, …(HCT) - CM / guarantee reparation(part. HCT) - CM / …. ….according to specific situation in enterprise - CM / launching to market(to cover product mktg. costs) = Production + other costs - Another Direct pre-production, production, post-production (e.g. packing)costs = Indirect production costs(HCT) Conclusion:By application of TC, the minimizing of time/unit consumption + maximizing of capacity utilization.

27. Final Conclusions to Cost Control(FCCC-1) • If you want to effect Costs, you has to effect on Activities  the Cost Control = requires to control Activities  (1)Which Activities (lean point of view) are really neededto be applied to produce PRODUCTS + necessary to support key processes needed for producing products (2)Activities: • In which way to realize the Activities • which kind of Activities (to substitute ACT with other kind of ACT?) • make or buy • or in cooperation (mix of make + buy) • Under which conditions • In which scope  ABC = Activity Based Costing (!!! but what does it mean actually?)