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Managing costs & mcs by bhawani nandan prasad iim calcutta

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Bhawani N Prasad
Bhawani N Prasad

This document provides an overview of managing costs and management control systems. It discusses: 1. The role of cost information in problem solving, record keeping, and directing attention. 2. Changes in the operating environment such as information technology, shortened product lifecycles, and increased customer focus that impact cost management. 3. Classifications of costs including direct vs indirect, variable vs fixed, and historical vs budgeted costs. It also discusses cost objects like products, departments, and specific units that costs can be assigned to.

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Managing Costs & Management Control Systems BHAWANI NANDAN PRASAD SMP – IIM Calcutta MBA – Stratford University B.E. ( Computer Sc. IT )
Managing Costs
Role of Cost Information  Problem Solving  Record Keeping  Attention Directing
* Information Technology * Shortening Product Life Cycles * Advanced Manufacturing Environments * Customer Focus * Economies Of Scope * Shift in Skills Mix Changes In Operating Environment
Summary of Cost Classifications (1)  Ease Of Traceability to Cost Object  Direct  Indirect  Behaviour In Relation to Change in Cost Driver  Variable  Fixed  Averaging  Total Cost  Unit Cost
Summary of Cost Classifications (2)  Time When Computed  Historical Cost  Budgeted Cost
Cost Objects Products Product Costing - Job Costing - Process Costing Departments Responsibility ( Organisational Accounting Units ) - Budgetary Control - Cost Centres - Profit Centres - Investment Centres
Specific Units or Small Batches of Custom Made Products Mass Production of Like Units Job Order Product Costing Systems Process Product Costing Systems Product Costing
Cost Allocation – General Approach Cost Pool 1 Cost Pool 2 Cost Pool n Indirect Cost Pools Application Base 1 Application Base 2 Application Base 1 Indirect Cost Application Bases Indirect Costs Cost Object Direct Costs Direct Cost 1 Direct Cost 2 Direct Cost n Direct Costs Trace Costs Allocate Costs
Absorption Costing OVERHEAD COST RATE 1 RATE 2 RATE 3 A B C PRODN DEPTS DEPTL.OH RATES PRODUCTS STAGE 1: O/H Assigned to Prodn Depts STAGE 2: O/H Allocated to Products
1. RELEVANT COST: Expected future costs that differ among alternative courses of action. 2. RELEVANT REVENUE: Expected revenue that differ among alternative courses of action. 3. INCREMENTAL COST: Change In Relevant Cost. 4. SUNK COSTS: Past costs that cannot be changed no matter what action is taken. 5. DISCRETIONARY COSTS: Arise from periodical decisions regarding outlay to be incurred. Not tied to a clear Cause & Effect Relationship between Inputs & Outputs. 6. ENGINEERED COSTS : Clear Cause & Effect Relationship between Inputs and Outputs 7. OPPORTUNITY COSTS: Maximum available contribution to Profit that is forgone by using limited resources for a particular purpose. Decision Making : Relevant Costs & Relevant Revenues
Relevant Range VOLUME COST Relevant Range Relevant Time Period
Cost Behavior Assessment PREREQUISITES : • Standard Product Mix • Relevant Range • Constant Prices • Volume Based Cost Driver • Linear Cost Function Quantitative Method / Regression Account Analysis COST BEHAVIOR ANALYSIS • Engineered Costs • Committed Costs • Discretionary Costs Cost Classification & Behavior
Quantitative Methods • HIGH LOW • REGRESSION
Contribution Contribution = Sales – Variable Costs Break Even Point (BEP) BEP (in units) = Fixed Costs / Contribution per unit BEP (in revenue) = Fixed Costs / Contribution to Sales ratio
Sales / Cost Loss Region BEP Fixed CostMargin of Safety < > Current Volume Volume Variable Costs & Fixed Costs Sales Profit Region B.E.P Fixed Costs / C/S Ratio M/S Profit / C/S Ratio Assumptions: 1. Linear Costs i.Selling Prices Variable Cost/Unit Constant ii.Total Fixed Cost Constant iii.Efficiency & Productivity Remains Constant 2. Volume Only Cost Driver 3. Production Volume = Sales Volume 4. No Inflation 5. Production Mix Held Constant Cost - Volume – Profit (CVP) Analysis
Management Control Systems
Input-Process-Output Model Measures Input Measure Process Measure Output Measure Non-Financial New # engineering # product delivery # new products products hours milestones achieved introduced Order # telephone order completion # orders processing answering staff time processed Parts # components setup time % output units manufacture meeting specs meeting standard Financial New labour & Rs cost of % sales $ from products materials Rs. prototyping new products Order clerical labour Rs cost of backorder Rs cost per order processing Rs handling processed Parts Rs cost of setup Rs cost Rs cost per unit manufacture components cost of rework unit
Choosing What to Control (2) Control Inputs When Control Processes When Control Outputs When processes & outputs processes can be outputs can be observed are unobservable observed & measured & measured cost of input is high cost of measuring/ cost of measuring/ relative to value of monitoring process monitoring outputs output is low is low quality and/or standardization is safety is important critical for safety and/ or quality cause & effect cause & effect relationship is clear relationship is unclear proprietary processes innovation is desired give strategic advantage
Control alternatives • Controls can focus on: – the actions taken – the results produced – the types of people employed and their shared values and norms. Or any combination of those ... Action Controls Results Controls People Controls
Control Alternatives (Mechant) Can people be avoided? (e.g., automation, centralization) Control-problem avoidance Can you rely on people involved? Can you make people reliable? Have knowledge about what specific actions are desirable? Able to assess whether specific action was taken? Have knowledge about what results are desirable? Able to measure results? Yes No Yes No No Action controls People controls Results controls Yes Yes Yes No Yes No ? Yes
Cybernetic Model - Single Feed Back Environment Performance Operating Process Subordinate Manager Superior Manager BUDGETS / PLANS TASKS FEEDBACK FEEDBACK Planning & Control Systems
Major Features of Budgets • A budget is a quantitative expression of a plan of action and an aid to co- ordination and implementation • The master budget summarises the objectives of all sub units of an organisation. It quantifies management‟s expectations regarding future income, cash flows and financial position ROLE OF BUDGETS : * Planning of operations * Co-ordination of activities * Implementing plans * Authorizing actions * Motivating * Controlling & evaluating performance PLANNING PERFORMANCE EVALUATION COMMUNICATION & CO-ORDINATION
Steps in Budget Preparation 1. Sales / Revenue Budget 2. Production Budget 3. Factory Overhead Budget 4. Inventory Budget 5. Cost Of Goods Sold Budget 6. Marketing & Admin. Exp Budget 7. Profit Budget
Budget Basis FINANCIAL  Actual Cost From the Most Recent Period  Actual Cost from the Most Recent Period -Adjusted for expected improvement  Standard Costs – Based on an analysis of an efficiently operating manufacturing facility  Target Costs – Based on analysis of the leading competitor in an industry  Most Efficient Plant Costs – For a company with multiple plants having the same operations or producing the same product INTERNAL INTERNAL INTERNAL EXTERNAL EXTERNAL
Budget Basis (contd.) NON FINANCIAL MEASURES o Budgets & actual reults show the financial effects of how cost drivers are managed o Non financial measures are the primary means for exercising control on a continuing basis
Standard Costs • Carefully predetermined costs that are usually expressed on a per unit basis. Standards outline how a task should be accomplished in non financial terms & how much it should cost Standard costs help management to: • Build budgets • Gauge performance • Obtain product costs • Save record keeping costs • Standard costs refer to the cost of a single finished unit of output Budgeted costs refer to the total amount
Variance Analysis PRICE QUANTITYSTD. ACT. ACT. STD. STANDARD COST = STD.PRICE x STD. QUANTITY PRICE VARIANCE = ACT.QTY * (STD.PRICE – ACT.PRICE) EFFICIENCY VARIANCE = STD.PRICE * (STD.QTY – ACT,QTY)
Types of Budgets  STATIC  FLEXIBLE STATIC BUDGET ACTUAL RESULTS FLEXIBLE BUDGET FLEXIBLE BUDGET VARIANCE SALES VOLUME VARIANCE UNITS SOLD 1,000 800 800 200 UF REVENUE 30,000 23,200 24,000 800 UF 6,000 UF VARIABLE COST 20,000 16,800 16,000 800 UF 4,000 UF OVERHEADS 5,000 5,500 5,000 500 UF CONTRIBUTION 10,000 6,400 8,000 1,600 UF 2,000 UF PROFIT 5,000 900 3,000 2,100 UF 2,000 UF
Sources of Variance 1. Inefficiencies in operations / breakdown of plan implementation 2. Inappropriate standard 3. Mis-measurement of actual results 4. Parameter prediction error 5. Randomness of operating processes
Variance Investigation Strategies • Investigate ALL variances • Investigate ALL variances greater than a specified percentage from standard • Investigate ALL variances greater than an absolute Rs. Amount • Investigate ALL variances on the basis of statistical control charts • Cost-benefit analysis of variance investigation decisions
Statistical Control Charts and Variance Investigation 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 19 20 21 22 PERIOD MATERIAL USE * O X * * * * * * * * * * * * * O O O O O O O O O O O X X X X X X X X X X X PROCESS 1 PROCESS 2 PROCESS 3
Concerns with “traditional” Budgeting • Prevalence of the use of fixed performance contracts • Excessive amount of time spent on budgeting • Unpredictability of the environment • Budgets cannot help firm adapt to change • Budgeting‟s inherent disconnect with strategy • Extent of people‟s dissatisfaction with budgeting Source : Beyond Budgeting or Budgeting Reconsidered? A survey of North American budgeting Practice (Theresa Libby & R Murray Lindsay)
Criticisms of Budgeting • Involve (organizational) politics and gameplaying. • Encourage incremental, rigid thinking. • Centralizes power and stifles initiative. • Too much concentration on quantifiable, monetary and short term measures. • Focus on cost reduction, rather than value creation. • Too many costs for too few benefits. Possible reforms: rolling budgets, Balanced Score Card approach. Has the increased unpredictability and volatility that we now witness make budgeting less relevant?
Framework for Designing Performance Measurement Systems Strategy What counts, gets measured What gets measured gets done What gets done gets rewarded What gets rewarded really counts! What you measure is what you get
Balanced Score Card (BSC) Designed to overcome the limitations of systems that are solely financially focused. Key Success Factors (KSFs) are typically classified in four perspectives: 1. Financial perspective (financial measures) 2. Customer perspective (customer satisfaction) 3. Internal business process perspective (e.g., productivity and speed) 4. Learning and innovation (e.g., training and number of new patents or products) As can be seen above, the BSC focuses not just on financial factors but several non – financial factors as well
The 4 Perspectives of the BSC Financial Objectives Measures Targets Initiatives Intl Business Processes Objectives Measures Targets Initiatives Customer Objectives Measures Targets Initiatives Learning & Growth Objectives Measures Targets Initiatives Vision and Strategy To achieve our vision how should we appear to our customers? To succeed financially, how should we appear to our shareholders? To satisfy our shareholders and customers, what business processes must we excel at? To achieve our vision, how will we sustain our ability to change and improve?
• The fifth perspective for many organizations • The balancing of short-term and long-term goals in all three dimensions of the company’s performance–economic, social, and environmental: – Environmental reports use environmental performance indicators (EPIs) to measure sustainability – These indicators are in three areas: • Operational (measure stresses to the environment/regulatory compliance issues) • Management (try to reduce environmental effects) • Environmental condition (measure environmental quality) Sustainability
Using Leading and Lagging Indicators in Balanced Scorecards Lead Financial performance Lead Customer value Lead Business and production process efficiency Organizational learning and growth Leading indicators Lagging indicator Leading indicators are measures that identify future nonfinancial and financial outcomes to guide management decision making. Lagging indicators are measures of the final outcomes of earlier management plans and their execution.
Balanced Score Card (BSC) 1.Financial and non-financial 2.Leading and lagging 3.Internal and external 4.Quantitative and qualitative 5.Short term and long term The term “balanced” arises because contrasting perspectives are considered while measuring organizational performance
A strategy map is a cause-and-effect diagram of the relationships embodied in a BSC: – Shows how the achievement of CSFs in one perspective should affect the achievement of goals in another perspective – The financial perspective is the target in the strategy map because financial performance is the ultimate goal for most profit-seeking organizations – Success in the other perspectives leads directly to improved financial performance and shareholder value Strategy Map
BSC – Simple Strategy Map
Some Issues – BSC • Search for a balance of measures a tough task • Subjective measures causes uncertainty, gaming and behavioral displacements and hence costs • Tough balancing of finance and non finance measures, usually the finance measures “win”! • There may be frequent need to change measures, parameters and weightings But a “correct” implementation of BSC clearly has many vital spin-off benefits ranging from strategy implementation to providing a basis for better evaluation of performance (?)
Balanced Scorecard – Problem Areas (example)  Ongoing defect rate dropped from 500 to 50 ppm  Yield increased from 26 to 51%  One time delivery improved from 70 to 96%  During the same period, the company’s performance showed little improvement and the stock price at the end of 1990 was approximately one-third of its July 1987 value! A large electronics firm made huge improvements in quality and on-time delivery performance over a three year period 1987 -19901: Moral of the story : define measures with care and provide appropriate weighting
In sum ... • The BSC is future-oriented. • It is perhaps particularly useful if an organization that is undergoing significant change or if management wants to shift the strategic focus. • It is a costly process, but with demands for change in an organization, its benefits may outweigh the costs.
Beyond Budgeting • A break from the budgeting process, based on the growing need to satisfy customers and optimise performance by relying on a company’s intellectual assets to manage an increasingly volatile and unpredictable environment with shifting product markets • This approach emphasizes: – rolling forecasts and optimization of resources – no evaluation on meeting specific targets – decentralized decision making and teams – a climate based on sustained competitive success – transparent and open information systems
Beyond Budgeting Stresses the importance of culture and managing culture
Traditional Budgets & the Beyond Budgeting Model Traditional (budget based) Mgmt. Model BBM Model Target & rewards •Incremental targets •Fixed incentives •Stretch goals •Relative rewards Planning & controls •Fixed annual plans •Variance controls •Cont. planning •KPI’s & rolling forecasts Resources & coordination •Pre-allocated resources •Central coordination •Resources on demand •Dynamic coord. Organ. & culture •Central control •Focus on managing #s •Local control of goals/plans •Focus on value creation Source : Beyond Budgeting in Statoil (Bjarte Bogsnes )
Empirical Evidence ? An Academic Viewpoint • BB presented as a universal prescription – Yet why do so many firms continue to use budgeting? – Some highly successful firms use budgeting extensively • Need deeper theory to explain why the BB model is superior • Assumptions (stated earlier) are under-researched and likely over- generalized Source : Beyond Budgeting or Budgeting Reconsidered? A survey of North American budgeting Practice (Theresa Libby & R Murray Lindsay)
Some Issues to ponder • Keeping forecasts and targets different – does this create a problem? – What if the targets were achieved? – The system assumes targets may not be achieved and yet evaluates managers on their achievement! • Performance targets for costs based on benchmarks. – Any adjustments done for size, technology, location? • Rolling financial plans clearly allow a better look-ahead. – But successful companies may be employing this technique anyway…. – Also using „back of an envelope‟ estimates could jeopardize accuracy. Is necessary accuracy assured for long term financial plans? • KPIs based on benchmarks are a great idea, though some the concerns surrounding the BSC model need revisiting

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Managing costs & mcs by bhawani nandan prasad iim calcutta

  • 1. Managing Costs & Management Control Systems BHAWANI NANDAN PRASAD SMP – IIM Calcutta MBA – Stratford University B.E. ( Computer Sc. IT )
  • 3. Role of Cost Information  Problem Solving  Record Keeping  Attention Directing
  • 4. * Information Technology * Shortening Product Life Cycles * Advanced Manufacturing Environments * Customer Focus * Economies Of Scope * Shift in Skills Mix Changes In Operating Environment
  • 5. Summary of Cost Classifications (1)  Ease Of Traceability to Cost Object  Direct  Indirect  Behaviour In Relation to Change in Cost Driver  Variable  Fixed  Averaging  Total Cost  Unit Cost
  • 6. Summary of Cost Classifications (2)  Time When Computed  Historical Cost  Budgeted Cost
  • 7. Cost Objects Products Product Costing - Job Costing - Process Costing Departments Responsibility ( Organisational Accounting Units ) - Budgetary Control - Cost Centres - Profit Centres - Investment Centres
  • 8. Specific Units or Small Batches of Custom Made Products Mass Production of Like Units Job Order Product Costing Systems Process Product Costing Systems Product Costing
  • 9. Cost Allocation – General Approach Cost Pool 1 Cost Pool 2 Cost Pool n Indirect Cost Pools Application Base 1 Application Base 2 Application Base 1 Indirect Cost Application Bases Indirect Costs Cost Object Direct Costs Direct Cost 1 Direct Cost 2 Direct Cost n Direct Costs Trace Costs Allocate Costs
  • 10. Absorption Costing OVERHEAD COST RATE 1 RATE 2 RATE 3 A B C PRODN DEPTS DEPTL.OH RATES PRODUCTS STAGE 1: O/H Assigned to Prodn Depts STAGE 2: O/H Allocated to Products
  • 11. 1. RELEVANT COST: Expected future costs that differ among alternative courses of action. 2. RELEVANT REVENUE: Expected revenue that differ among alternative courses of action. 3. INCREMENTAL COST: Change In Relevant Cost. 4. SUNK COSTS: Past costs that cannot be changed no matter what action is taken. 5. DISCRETIONARY COSTS: Arise from periodical decisions regarding outlay to be incurred. Not tied to a clear Cause & Effect Relationship between Inputs & Outputs. 6. ENGINEERED COSTS : Clear Cause & Effect Relationship between Inputs and Outputs 7. OPPORTUNITY COSTS: Maximum available contribution to Profit that is forgone by using limited resources for a particular purpose. Decision Making : Relevant Costs & Relevant Revenues
  • 13. Cost Behavior Assessment PREREQUISITES : • Standard Product Mix • Relevant Range • Constant Prices • Volume Based Cost Driver • Linear Cost Function Quantitative Method / Regression Account Analysis COST BEHAVIOR ANALYSIS • Engineered Costs • Committed Costs • Discretionary Costs Cost Classification & Behavior
  • 14. Quantitative Methods • HIGH LOW • REGRESSION
  • 15. Contribution Contribution = Sales – Variable Costs Break Even Point (BEP) BEP (in units) = Fixed Costs / Contribution per unit BEP (in revenue) = Fixed Costs / Contribution to Sales ratio
  • 16. Sales / Cost Loss Region BEP Fixed CostMargin of Safety < > Current Volume Volume Variable Costs & Fixed Costs Sales Profit Region B.E.P Fixed Costs / C/S Ratio M/S Profit / C/S Ratio Assumptions: 1. Linear Costs i.Selling Prices Variable Cost/Unit Constant ii.Total Fixed Cost Constant iii.Efficiency & Productivity Remains Constant 2. Volume Only Cost Driver 3. Production Volume = Sales Volume 4. No Inflation 5. Production Mix Held Constant Cost - Volume – Profit (CVP) Analysis
  • 18. Input-Process-Output Model Measures Input Measure Process Measure Output Measure Non-Financial New # engineering # product delivery # new products products hours milestones achieved introduced Order # telephone order completion # orders processing answering staff time processed Parts # components setup time % output units manufacture meeting specs meeting standard Financial New labour & Rs cost of % sales $ from products materials Rs. prototyping new products Order clerical labour Rs cost of backorder Rs cost per order processing Rs handling processed Parts Rs cost of setup Rs cost Rs cost per unit manufacture components cost of rework unit
  • 19. Choosing What to Control (2) Control Inputs When Control Processes When Control Outputs When processes & outputs processes can be outputs can be observed are unobservable observed & measured & measured cost of input is high cost of measuring/ cost of measuring/ relative to value of monitoring process monitoring outputs output is low is low quality and/or standardization is safety is important critical for safety and/ or quality cause & effect cause & effect relationship is clear relationship is unclear proprietary processes innovation is desired give strategic advantage
  • 20. Control alternatives • Controls can focus on: – the actions taken – the results produced – the types of people employed and their shared values and norms. Or any combination of those ... Action Controls Results Controls People Controls
  • 21. Control Alternatives (Mechant) Can people be avoided? (e.g., automation, centralization) Control-problem avoidance Can you rely on people involved? Can you make people reliable? Have knowledge about what specific actions are desirable? Able to assess whether specific action was taken? Have knowledge about what results are desirable? Able to measure results? Yes No Yes No No Action controls People controls Results controls Yes Yes Yes No Yes No ? Yes
  • 22. Cybernetic Model - Single Feed Back Environment Performance Operating Process Subordinate Manager Superior Manager BUDGETS / PLANS TASKS FEEDBACK FEEDBACK Planning & Control Systems
  • 23. Major Features of Budgets • A budget is a quantitative expression of a plan of action and an aid to co- ordination and implementation • The master budget summarises the objectives of all sub units of an organisation. It quantifies management‟s expectations regarding future income, cash flows and financial position ROLE OF BUDGETS : * Planning of operations * Co-ordination of activities * Implementing plans * Authorizing actions * Motivating * Controlling & evaluating performance PLANNING PERFORMANCE EVALUATION COMMUNICATION & CO-ORDINATION
  • 24. Steps in Budget Preparation 1. Sales / Revenue Budget 2. Production Budget 3. Factory Overhead Budget 4. Inventory Budget 5. Cost Of Goods Sold Budget 6. Marketing & Admin. Exp Budget 7. Profit Budget
  • 25. Budget Basis FINANCIAL  Actual Cost From the Most Recent Period  Actual Cost from the Most Recent Period -Adjusted for expected improvement  Standard Costs – Based on an analysis of an efficiently operating manufacturing facility  Target Costs – Based on analysis of the leading competitor in an industry  Most Efficient Plant Costs – For a company with multiple plants having the same operations or producing the same product INTERNAL INTERNAL INTERNAL EXTERNAL EXTERNAL
  • 26. Budget Basis (contd.) NON FINANCIAL MEASURES o Budgets & actual reults show the financial effects of how cost drivers are managed o Non financial measures are the primary means for exercising control on a continuing basis
  • 27. Standard Costs • Carefully predetermined costs that are usually expressed on a per unit basis. Standards outline how a task should be accomplished in non financial terms & how much it should cost Standard costs help management to: • Build budgets • Gauge performance • Obtain product costs • Save record keeping costs • Standard costs refer to the cost of a single finished unit of output Budgeted costs refer to the total amount
  • 28. Variance Analysis PRICE QUANTITYSTD. ACT. ACT. STD. STANDARD COST = STD.PRICE x STD. QUANTITY PRICE VARIANCE = ACT.QTY * (STD.PRICE – ACT.PRICE) EFFICIENCY VARIANCE = STD.PRICE * (STD.QTY – ACT,QTY)
  • 29. Types of Budgets  STATIC  FLEXIBLE STATIC BUDGET ACTUAL RESULTS FLEXIBLE BUDGET FLEXIBLE BUDGET VARIANCE SALES VOLUME VARIANCE UNITS SOLD 1,000 800 800 200 UF REVENUE 30,000 23,200 24,000 800 UF 6,000 UF VARIABLE COST 20,000 16,800 16,000 800 UF 4,000 UF OVERHEADS 5,000 5,500 5,000 500 UF CONTRIBUTION 10,000 6,400 8,000 1,600 UF 2,000 UF PROFIT 5,000 900 3,000 2,100 UF 2,000 UF
  • 30. Sources of Variance 1. Inefficiencies in operations / breakdown of plan implementation 2. Inappropriate standard 3. Mis-measurement of actual results 4. Parameter prediction error 5. Randomness of operating processes
  • 31. Variance Investigation Strategies • Investigate ALL variances • Investigate ALL variances greater than a specified percentage from standard • Investigate ALL variances greater than an absolute Rs. Amount • Investigate ALL variances on the basis of statistical control charts • Cost-benefit analysis of variance investigation decisions
  • 32. Statistical Control Charts and Variance Investigation 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 19 20 21 22 PERIOD MATERIAL USE * O X * * * * * * * * * * * * * O O O O O O O O O O O X X X X X X X X X X X PROCESS 1 PROCESS 2 PROCESS 3
  • 33. Concerns with “traditional” Budgeting • Prevalence of the use of fixed performance contracts • Excessive amount of time spent on budgeting • Unpredictability of the environment • Budgets cannot help firm adapt to change • Budgeting‟s inherent disconnect with strategy • Extent of people‟s dissatisfaction with budgeting Source : Beyond Budgeting or Budgeting Reconsidered? A survey of North American budgeting Practice (Theresa Libby & R Murray Lindsay)
  • 34. Criticisms of Budgeting • Involve (organizational) politics and gameplaying. • Encourage incremental, rigid thinking. • Centralizes power and stifles initiative. • Too much concentration on quantifiable, monetary and short term measures. • Focus on cost reduction, rather than value creation. • Too many costs for too few benefits. Possible reforms: rolling budgets, Balanced Score Card approach. Has the increased unpredictability and volatility that we now witness make budgeting less relevant?
  • 35. Framework for Designing Performance Measurement Systems Strategy What counts, gets measured What gets measured gets done What gets done gets rewarded What gets rewarded really counts! What you measure is what you get
  • 36. Balanced Score Card (BSC) Designed to overcome the limitations of systems that are solely financially focused. Key Success Factors (KSFs) are typically classified in four perspectives: 1. Financial perspective (financial measures) 2. Customer perspective (customer satisfaction) 3. Internal business process perspective (e.g., productivity and speed) 4. Learning and innovation (e.g., training and number of new patents or products) As can be seen above, the BSC focuses not just on financial factors but several non – financial factors as well
  • 37. The 4 Perspectives of the BSC Financial Objectives Measures Targets Initiatives Intl Business Processes Objectives Measures Targets Initiatives Customer Objectives Measures Targets Initiatives Learning & Growth Objectives Measures Targets Initiatives Vision and Strategy To achieve our vision how should we appear to our customers? To succeed financially, how should we appear to our shareholders? To satisfy our shareholders and customers, what business processes must we excel at? To achieve our vision, how will we sustain our ability to change and improve?
  • 38. • The fifth perspective for many organizations • The balancing of short-term and long-term goals in all three dimensions of the company’s performance–economic, social, and environmental: – Environmental reports use environmental performance indicators (EPIs) to measure sustainability – These indicators are in three areas: • Operational (measure stresses to the environment/regulatory compliance issues) • Management (try to reduce environmental effects) • Environmental condition (measure environmental quality) Sustainability
  • 39. Using Leading and Lagging Indicators in Balanced Scorecards Lead Financial performance Lead Customer value Lead Business and production process efficiency Organizational learning and growth Leading indicators Lagging indicator Leading indicators are measures that identify future nonfinancial and financial outcomes to guide management decision making. Lagging indicators are measures of the final outcomes of earlier management plans and their execution.
  • 40. Balanced Score Card (BSC) 1.Financial and non-financial 2.Leading and lagging 3.Internal and external 4.Quantitative and qualitative 5.Short term and long term The term “balanced” arises because contrasting perspectives are considered while measuring organizational performance
  • 41. A strategy map is a cause-and-effect diagram of the relationships embodied in a BSC: – Shows how the achievement of CSFs in one perspective should affect the achievement of goals in another perspective – The financial perspective is the target in the strategy map because financial performance is the ultimate goal for most profit-seeking organizations – Success in the other perspectives leads directly to improved financial performance and shareholder value Strategy Map
  • 42. BSC – Simple Strategy Map
  • 43. Some Issues – BSC • Search for a balance of measures a tough task • Subjective measures causes uncertainty, gaming and behavioral displacements and hence costs • Tough balancing of finance and non finance measures, usually the finance measures “win”! • There may be frequent need to change measures, parameters and weightings But a “correct” implementation of BSC clearly has many vital spin-off benefits ranging from strategy implementation to providing a basis for better evaluation of performance (?)
  • 44. Balanced Scorecard – Problem Areas (example)  Ongoing defect rate dropped from 500 to 50 ppm  Yield increased from 26 to 51%  One time delivery improved from 70 to 96%  During the same period, the company’s performance showed little improvement and the stock price at the end of 1990 was approximately one-third of its July 1987 value! A large electronics firm made huge improvements in quality and on-time delivery performance over a three year period 1987 -19901: Moral of the story : define measures with care and provide appropriate weighting
  • 45. In sum ... • The BSC is future-oriented. • It is perhaps particularly useful if an organization that is undergoing significant change or if management wants to shift the strategic focus. • It is a costly process, but with demands for change in an organization, its benefits may outweigh the costs.
  • 46. Beyond Budgeting • A break from the budgeting process, based on the growing need to satisfy customers and optimise performance by relying on a company’s intellectual assets to manage an increasingly volatile and unpredictable environment with shifting product markets • This approach emphasizes: – rolling forecasts and optimization of resources – no evaluation on meeting specific targets – decentralized decision making and teams – a climate based on sustained competitive success – transparent and open information systems
  • 47. Beyond Budgeting Stresses the importance of culture and managing culture
  • 48. Traditional Budgets & the Beyond Budgeting Model Traditional (budget based) Mgmt. Model BBM Model Target & rewards •Incremental targets •Fixed incentives •Stretch goals •Relative rewards Planning & controls •Fixed annual plans •Variance controls •Cont. planning •KPI’s & rolling forecasts Resources & coordination •Pre-allocated resources •Central coordination •Resources on demand •Dynamic coord. Organ. & culture •Central control •Focus on managing #s •Local control of goals/plans •Focus on value creation Source : Beyond Budgeting in Statoil (Bjarte Bogsnes )
  • 49. Empirical Evidence ? An Academic Viewpoint • BB presented as a universal prescription – Yet why do so many firms continue to use budgeting? – Some highly successful firms use budgeting extensively • Need deeper theory to explain why the BB model is superior • Assumptions (stated earlier) are under-researched and likely over- generalized Source : Beyond Budgeting or Budgeting Reconsidered? A survey of North American budgeting Practice (Theresa Libby & R Murray Lindsay)
  • 50. Some Issues to ponder • Keeping forecasts and targets different – does this create a problem? – What if the targets were achieved? – The system assumes targets may not be achieved and yet evaluates managers on their achievement! • Performance targets for costs based on benchmarks. – Any adjustments done for size, technology, location? • Rolling financial plans clearly allow a better look-ahead. – But successful companies may be employing this technique anyway…. – Also using „back of an envelope‟ estimates could jeopardize accuracy. Is necessary accuracy assured for long term financial plans? • KPIs based on benchmarks are a great idea, though some the concerns surrounding the BSC model need revisiting