Chapter 15 Financial Management Questions The cost control system is an integral part of the cost management system The cost control system provides information for planning purposes and, subsequently, for evaluation of actual performance Without first establishing performance targets and benchmarks, control systems cannot function The purpose of establishing control systems is to guide the organization toward its established objectives Accordingly, the control cycle must begin with the establishment of plans that define where the organization is headed and what its managers want to accomplish Cost control for any specific event is exerted before, during, and after the event Cost control is exerted before the event to determine the expected cost and to provide a plan to achieve the expected cost During an event, control is exerted to maintain the cost being incurred at the planned level After an event, actual performance is compared to planned performance and explanations of differences are developed By understanding why differences exist, managers can take actions to minimize future differences between the actual and planned amounts 145 146 Chapter 15 Financial Management Factors potentially causing a cost to change include: (1) changes in activity level; (2) change in inflation/deflation; (3) technology changes; (4) changes in supply and demand; (5) quantity of competition; (6) seasonality and other timing phenomena; and (7) quantity purchased Factors and 5-7 are most subject to cost containment The difference in controllability is the extent to which the factor can be influenced by actions of managers The factors that are external to the firm are less subject to control than (e.g., inflation) internal factors (e.g., activity levels) General price-level changes are reflected economy-wide Prices for all goods and services rise at comparable rates Specific price-level changes affect only certain industries, parts or commodities General and specific price-level changes are similar in that their effects are similar-prices or goods and services rise or fall They differ in that general price-level changes are caused by macroeconomic factors such as the supply of money and the rate of inflation Specific price-level changes are caused by specific events such as the Gulf War, weather, or interruption of the distribution channel By cooperating with members of the supply chain, an organization creates an opportunity for interorganizational cost management In sharing information, suppliers can inform customers about alternatives that would lower the suppliers’ costs and result in reduced prices to the customers Additionally, opportunities for outsourcing activities may be identified for circumstances in which a supplier firm can provide a service, commodity, or part at a lower cost than the customer firm This statement is not true Single-source contracts have the potential to provide two advantages The first is volumebased purchasing High-volume purchasing should command a lower price Secondly, single-source purchasing offers greater opportunities for sharing information between supplier and customer firms to identify ways to jointly reduce costs and increase profits However, only if these two opportunities are actively pursued will cost benefits be realized Further, for commodity goods, single-source purchasing may offer no advantages because the purchase price is determined strictly by the market Chapter 15 147 Financial Management Cost avoidance means not spending money for unneeded goods or services; cost reduction refers to using fewer goods or services to lower expenditures The former often means finding alternatives to avoid using the goods or services whereas the latter usually means using fewer of the same goods or services Temporaries are used to avoid paying extra full-time personnel for work that is only needed to meet peak loads Temporary workers can be “fired” after the need for their contribution abates Use of temporaries also avoids paying all of the fringe benefit costs associated with full-time employees and can provide the special expertise that is not available from full-time employees However, use of temporaries creates new problems For example, temporaries have no loyalty to the company because they know they have only temporary positions Further, temporary employees may demand much higher pay than permanent workers to compensate for the absence of fringe benefits and the security of a permanent position Use of temporary workers may also cause problems of job or task continuity because of worker turnover 10 Total fixed costs can be dichotomized into two groups, committed and discretionary The committed fixed costs are ones that are less susceptible to cost control efforts, at least during the short run These costs consist of costs associated with basic plant assets and organizational infrastructure Discretionary fixed costs are more susceptible to short-run cost control efforts Discretionary fixed costs are incurred as a result of managerial judgment Examples of such costs are research and development and advertising Costs considered as committed by one firm may be considered discretionary by other firms For example, a firm that competes on the basis of products containing the latest functionality and technology would consider research and development to be committed A firm that competes on the basis of price might consider research and development to be discretionary 11 No all discretionary costs are not fixed; some can be variable For example, a firm may decide to spend one cent of each sales dollar on advertising This is an example of a discretionary variable cost 148 12 Chapter 15 Financial Management Heavy investment in automated technology affects a firm’s cost structure The main effect is an increase in committed fixed costs A negative consequence is that, as the proportion of committed fixed costs to total costs rises, fewer and fewer costs are avoidable as sales fall The result can be substantial operating losses in economic downturns Such losses can threaten the ability of the firm to remain solvent and survive Even so, as an industry becomes more and more competitive, firms will make increased investment in automated technology to control operating costs and quality The challenge for such an industry then becomes finding ways to maintain sales volume during economic slumps 13 Issues to be considered when setting discretionary cost appropriations are: · What discretionary activities should be funded to help management effectively and efficiently achieve its objectives? · Can management satisfactorily determine if the activities are the cause of alleged benefits? · Are prospects for profits adequate to support the planned discretionary activities? 14 Committed fixed costs are incurred based on long-term considerations and are simply not controllable in the short term Discretionary fixed costs can be increased or decreased to manage income and cash flow The budgeted amounts for discretionary fixed costs are therefore much more likely to be determined by short-run objectives Even so, some discretionary fixed costs (e.g., maintenance, research and development) are incurred for long-term benefit and will be less correlated with short-term objectives such as profit and cash flow 15 Many types of discretionary costs not have outputs for which there is a precisely explainable and predictable technical relationship with inputs When an output measure is devised, it is normally available only in nonmonetary, surrogate terms For some discretionary costs such as research and development, output may result, if at all, only after making inputs for a period of indefinite duration Thus, even when outputs occur, it is difficult to relate them to a particular period's input 16 A surrogate measure of output is an indirect or substitute measure The results of discretionary cost activities are often not susceptible to direct financial measurement so nonmonetary surrogate measures are used 17 Chapter 15 149 Financial Management Efficiency is a measure of the degree to which the actual yield ratio (actual output ÷ actual input) conforms to the desired yield ratio (planned output ÷ planned input) Effectiveness is a measure of the degree to which a goal or objective is achieved Measuring the efficiency of a discretionary cost requires both a measure of input and a measure of output Efficiency further requires a predictable cause-and-effect relationship between input and output Input costs are readily measured However, as explained in the answer to Question 15, outputs are not normally readily available When they are readily available or when surrogates can be identified, there is still often a lack of confidence about the strength of the causeand-effect relationship between input and output for most discretionary costs To measure effectiveness of a discretionary activity, an output measure, either monetary or nonmonetary, must be available or devised Sometimes a surrogate measure for output of an activity can be agreed on Effectiveness of a discretionary cost can then be measured by comparing actual output to planned output (i.e., actual output ÷ planned output) 18 Management performance is evaluated by how efficiently and effectively the company's goals are achieved Efficiency measures the relationship between inputs and outputs Effectiveness compares outputs to objectives Objectives are short-run targets set to achieve long-run goals Thus, there is a linkage starting with inputs and ending with goal achievement to measure the efficiency and effectiveness with which managers have performed 19 Engineered costs, unlike most discretionary costs, bear a constant and observable relationship to changes in an activity However, some discretionary costs can, under the appropriate conditions, be treated as if they were engineered costs for the purpose of control If output measures can be identified, then yield ratios (output ÷ input) can be devised to evaluate control of discretionary costs 20 Quality control inspection cost is sometimes susceptible to treatment as an engineered cost Other examples of activities that could be engineered include maintenance tasks, machine setups, and employee training activities 150 21 Chapter 15 Financial Management Variance analysis can be used to evaluate cost control of engineered costs in a manner similar to that used in standard costing For a given engineered cost, the difference between the flexible budget amount and actual cost is determined This amount is the total variance This total amount can be divided into a price and efficiency variance The price variance captures the amount of the total variance due to paying more or less than the budgeted amount per unit of input The efficiency variance is the amount of the total variance that is due to using a total input quantity that is above or below the budgeted input quantity 22 Budget-to-actual comparisons are necessary to control the level of spending on discretionary fixed costs Only by such comparisons will total expenditures on such costs be controlled However, budget-to-actual comparisons should not be the only control measure Additional analysis should determine whether the budgeted activities were at the expected level 23 A planning budget is fixed at a given level of output volume Often, the actual output level will not conform to this planned level of output Accordingly, costs and revenues will differ from the budgeted level because of volume differences In evaluating the performance of managers who have no control over volume, it is desirable to have a budget that is based on the actual volume level Accordingly, a flexible budget is used to evaluate the success of such managers and it is compiled at the actual level of activity 24 Activity-based budgeting is an improvement over traditional budgeting in that costs are organized by activities that are necessary for the organization to achieve its objectives This approach makes more transparent to managers what consequences would result if particular costs were cut It also serves to highlight the cost of activities that aren’t necessary to achieving organizational objectives 25 Firms hold cash balances to liquidate planned transactions as they occur, to cover cash consequences of unexpected events, and for speculative purposes Some firms must carry relatively larger cash balances than other firms because either the cash required to maintain the liquidity of the operating cycle is less predictable, or the ability to obtain cash from financing sources is more constrained 26 Chapter 15 151 Financial Management Program budgeting is typically used in governmental agencies or for special initiatives in private firms The process of program budgeting begins with a specification of the objectives to be achieved from the initiative or “program.” Then, alternatives to achieving the objectives are identified Finally, costs are budgeted for the activities that are selected to generate the desired objectives The process of a zero-base budget begins with no assumptions based on prior years’ data Each activity and dollar must be justified based on their contribution to organizational goals A traditional budget has as its starting point a sales projection and cost data from prior periods Past relationships between costs and activities are used as the basis to extrapolate and budget the level of future costs 27 Program budgeting requires the use of detailed surrogate measures which necessitates answering several questions: • What results should be measured? • What results are significant enough to develop output measures? • Can cause be established between programs and results? and, • Does the program affect the target population? Determining answers to these questions can be very difficult Because many “programs” involve expenditures on discretionary activities, it is difficult to map inputs into outputs Although the costs of the inputs can be reasonably determined, the value of the outputs may be difficult to establish and the extent to which objectives have been achieved can be difficult to measure 28 Among the problems associated with zero-base budgeting are • Its cost Zero-base budgeting is much more expensive than traditional budgeting because of the added time involved • The requirement that all activities necessary to the achievement of an objective be specified This requirement implies that the benefits of discretionary activities can be measured For some activities, measurement of outputs can be very difficult • That it requires a total commitment from all personnel An organization must have the right culture to obtain this commitment Chapter 15 Financial Management 152 Exercises 29 a b c d e f g h i 30 a Cost reduction-because quantity of work fluctuates, parttime employees provide services for peak caseload times without full-time cost b Annual salary full-time clerical staff ($28,500 × 1.20) = $34,200; if 1,600 hours or less, part-time salary = $20X; if over 1,600 hours, part-time salary = $20X + $2,000 For 1,600 or fewer hours, point of indifference: $20X = $34,200 X = $34,200 ÷ 20 X = 1,710 hours For more than 1,600 hours: $20X + $2,000 = $34,200 $20X = $32,200 X = 1,610 hours Thus, the point of indifference occurs at 1,610 hours, the level that triggers the payment of the bonus 31 a b c d e f Cost understanding Cost reduction Cost avoidance for the cost of call-forwarding; the increase in costs for staff shows a recognition of client need and services to be provided Cost avoidance Cost reduction Cost avoidance of what would have been an increase in costs with the installation of the new telephones; also shows cost understanding since she knew why the cost would increase 32 a Chapter 15 153 Financial Management Classification Cost C Annual audit fees C Annual report preparation and printing C Building flood insurance D Charitable contributions D Corporate advertising D Employee continuing education C Office equipment depreciation C Interest on bonds payable D Internal audit salaries D Marketing research D Preventive maintenance C Property taxes D Quality control inspection D Research and development salaries D Research and development supplies (the amount is discretionary only if R&D is to be conducted internally) D Secretarial pool salaries b Building flood insurance, charitable contributions, corporate advertising, executive training, employee continuing education, internal audit salaries, marketing research, preventive maintenance, quality control inspection, research and development salaries, research and development supplies, secretarial pool salaries Cost Charitable contrib Chapter 15 Financial Management Surrogate Output Measure Improvement in social welfare Advertising Increase in sales Uncertainty about cause & effect Employee education Increase in productivity, quality Difficult to capture all costs and benefits Internal audit # of internal controls improved No single measure will capture all benefits of internal auditing Market research # of new products identified Doesn’t capture the value of the product ideas 154 c Objections Very difficult to measure Prev maint Reduction in number of breakdowns Age of machines plays a bigger role in # of breakdowns than maintenance does Q control Reduction in # of defective items returned by customers Other factors such as careless handling by those moving products may cause defects R & D salaries Number of discoveries, inventions, improvements, etc These outputs are so heterogeneous as to not be additive R & D supplies Expenditures per dollar of R&D salary Doesn’t capture benefits of expenditure Secr pool Number of documents prepared Does not necessarily measure quality of work 160 48 Chapter 15 Financial Management The firm may have too much cash invested in working capital The two accounts consuming the most cash are accounts receivable and work in process inventory Accounts receivable can be reduced by finding ways to speed up collections For example, arrangements can be made to electronically collect accounts from customers Terms of sale can be tightened and stricter policies for granting credit can be imposed For work in process inventory, ways can be found to reduce the inventory level For instance, by speeding up production processes, less time will be consumed from the start to completion of production Methods such as just-in-time inventory management would be useful Also, the company’s payables are very small relative to current assets Current payables can be used as free financing for current assets To illustrate, the company could negotiate for credit terms from its suppliers This credit would be a source of financing for inventory and accounts receivable and would free up cash the company currently has invested in these accounts Problems 49 a b c d e f g h i j k l 50 a CU CU CA CU CU CA or CR CA CR CU CA CC CA (From employer perspective) Advantages Disadvantages Less expensive Possibly lower quality Flexibility Not avail as much out of class b Lower cost Less loyalty to the firm c Greater availability of personnel Less expensive Possibly less competence Less continuity d Less expensive Flexibility Possibly poor quality writing Less control over writers 51 Chapter 15 161 Financial Management Possibly lower quality work Possibly less reliable Possibly less responsive Greater possibility of theft e Availability f Less expensive Availability Less training Possibly less loyalty Possibly poorer customer relat g Less expensive Possibly less reliable Possibly less control Possibly lower quality of work h Less expensive Possibly lower quality of work Possibly less reliable Possibly less control i More alert employees Less expensive Lower pension & benefits costs Possibly lower quality of work Possibly less competent workers Lack of company loyalty j Provides more flexible capacity Lower cost Availability of more workers Inconsistent work Reduced ability to control quality k Availability Better quality of life for Mom & Pop Less expensive Potential theft Potential damage to relations with customers a 7,800 × 98 = 7,644 flawless gaskets per kwh b Achieved efficiency per kWh = (1,390,000 – 17,900) ÷ 175 = 7,840.6 gaskets per kwh which exceeds the standard by 196.6 flawless gaskets per kWh c Achieved effectiveness = 17,900 ÷ 1,390,000 = 1.29% flaws, versus the expected 2.0% rate of flaws Thus, the machine is more effective in producing flawless output than claimed 162 d Chapter 15 Financial Management kWh at standard efficiency: [(1,390,000 – 17,900) ÷ 7,644] = 179.5 kWh Std kWh Act kWh kWh saved Cost per kWh Cost savings 52 179.50 175.00 4.50 × $3.20 $14.40 e An automobile manufacturer would want zero defects in the gaskets it purchases and would expect the vendor to have sufficient quality control measures to virtually ensure this a EDP Department Costs Variable Fixed Total Actual $ 87,750 402,000 $489,750 Appropriation $100,000 400,000 $500,000 Unexpended Appropriation $12,250 (2,000) $10,250 The EDP manager stayed within his $500,000 total appropriation even though he overspent on the fixed portion of it Top management would not view this as a problem unless the appropriation had been granted separately for the variable and fixed components rather than on a total basis b Actual output = 1950 = 0.975 Planned output 2000 The department was reasonably effective if the above ratio is a viable surrogate for effectiveness However, it is somewhat problematic in this case in that management has been looking askance at the rapid expansion of EDP department services Also, this calculation does not measure the quality of the output c Actual output Actual input vs Planned output Planned input Variable expenses efficiency: 1950 hours= hour per $45 vs 2000 hours= hour per $50 $87,750 $100,000 (actual efficiency exceeds expectations) Fixed expenses efficiency: 1950 hours= hr per $206 vs 2000 hours= hr per $200 $402,000 $400,000 (actual efficiency is slightly less) Chapter 15 Financial Management d 163 (1) Actual Actual Hrs × Std Rate Hrs.Earned × Std Rate 1,950 × $50 1,950 × $50 $87,750 $97,500 $97,500 | | | | | $9,750 F | | $0 | Spending Variance Efficiency Variance (note) | | | $9,750 F | Total Variable EDP Cost Variance Note: Since input hours of service are all assumed to be good hours of output in this case, there is no efficiency variance If a separate measure of output can be devised, an efficiency variance can be calculated (2) Actual Hrs Earned × Std Rate 1,950 × $200 $402,000 $400,000 $390,000 | | | | | $2,000 U | | $10,000 U | Spending Variance Volume Variance | | | $12,000 U | Total Fixed EDP Cost Variance e Budget To this, normal or anticipated hours of utilization must be specified In the case at hand, a first approximation can be found by dividing the current year budgeted fixed costs by the number of anticipated (budgeted) hours ($400,000 ÷ 2,000 = $200 per hour) and the budgeted variable costs by the budgeted service hours ($100,000 ÷ 2,000 = $50 per hour) Combining the fixed and variable rate ($200 plus $50), a total of $250 per hour of computer time is indicated It seems reasonable to believe that charging almost $250 per hour for computer time where there was no charge previously would cause a reduction in demand A reduction in demand would cause the fixed portion of EDP department costs to be averaged over fewer hours, resulting in an even higher charge per hour For instance, if demand could be expected to drop by 20 percent to 1,600 hours, then the fixed rate per hour would rise to $250 ($400,000 ÷ 1,600) and the total charging rate would rise to $300 per hour 164 53 54 a Chapter 15 Financial Management This finding represents both efficiency and effectiveness It is primarily for cost avoidance Use of simple, inexpensive antibiotics is found to be better treatment (more effective) and less expensive (more efficient) It is cost avoidance because it calls for using a lower-cost alternative b This finding represents efficiency It is primarily cost avoidance Watchful waiting does the job better than using expensive MRIs and is a lower cost substitute c This finding represents effectiveness Medical professionals find reduced likelihood of dying from heart attacks by prescribing aspirin and/or beta blockers d This finding represents effectiveness Medical professionals find that inhaled steroid medications can prevent disability and complications among asthmatic patients e This finding represents efficiency It is primarily cost avoidance Patients trained to avoid asthma triggers, measure their own lung function, follow a consistent treatment plan, and make adjustments in their own medications is a much lower cost substitute than extended hospital stays and emergency room visits a A flexible budget allows management to directly compare the actual cost of operations with budgeted costs for the activity achieved It assists management in evaluating the effects of varying levels of activity on costs, profits, and cash position, thus aiding in the choice of the level of operation for planning purposes The flexible budgets presented are based on three different activity measures, none of which coincides with the actual level of performance for November The budget must be restated to a level of activity that matches the actual results The fixed and variable components of the mixed costs must be segregated and a budgeted cost calculated for the level of activity attained b Chapter 15 165 Financial Management Sales salaries are the only cost that varies perfectly with number of salespersons ($90,000 ÷ 100 = $900) The following vary with sales orders: Sales commissions $300 per sales order Sales travel 100 per sales order ($50,000 assumed fixed) Sales off expense 30 per sales order ($400,000 assumed fixed) Shipping expense 100 per sales order ($500,000 assumed fixed) Total Var cost $530 per sales order c Johnson Lighting, Inc Selling Expense Report - November Monthly Expenses Adver & promo Admin salaries Sales salaries Sales commissions2 Salesperson travel3 Sales off expense4 Shipping expense5 Budget $1,500,000 75,000 81,000 447,000 199,000 448,000 660,000 $3,410,000 Actual $1,450,000 80,000 92,000 460,000 185,000 500,000 640,000 $3,407,000 Variance $50,000 5,000 11,000 13,000 14,000 52,000 20,000 $ 3,000 F U U U F U F U ($90,000/100) × 90 = $81,000 ($450,000ữ$15,000,000) ì $14,900,000 = $218,800 3Change in cost: $225,000 - $200,000 = $25,000 Change in sales dollars: $17,500,000-$15,000,000 = $2,500,000 Variable cost per dollar of sales = change in cost divided by change in activity level: $25,000÷$2,500,000 = $.01 per dollar of sales Fixed cost at $15,000,000: $200,000 - ($15,000,000 × 01) = $50,000 Total travel budget: $50,000 fixed + (14,900,000 × 01) =$199,000 (variable = $149,000) 4Change in cost: $452,500 - $445,000 = $7,500 Change in number of orders: 1,750 - 1,500 = 250 Variable cost per order: $7,500 ÷ 250 = $30 Fixed cost: $445,000 - (1,500 × $30) = $400,000 Total office expense budget: $400,000 + (1,600 × $30) = $448,000 5Change in cost: $675,000 - $650,000 = $25,000 Change in number of units: 17,500 - 15,000 = 2,500 Variable cost per unit: $25,000 ÷ 2,500 = $10.00 Fixed cost: $650,000 - (15,000 × $10.00) = $500,000 Total shipping expense budget: $500,000 + (16,000 × $10.00) = $660,000 166 d Chapter 15 Financial Management Sales salaries ÷ number of salespersons = $92,000 ÷ 90 = $1,022 fixed cost (rounded) Note: to estimate the actual variable cost portion of the mixed costs, we assume the fixed portion of the mixed cost was equal to the budgeted amount Actual variable cost per sales order: Commissions ÷ number of orders = $460,000 ÷ 1,600 = $287.50 Variable travel ÷ number of orders = ($185,000 - $50,000) ÷ 1,600 = $84.38 (rounded) Variable office expense ÷ number of orders = ($500,000 $400,000) ÷ 1,600 = $62.50 Variable shipping expense ÷ number of orders = ($640,000 - $500,000) ÷ 1,600 = $87.50 55 e To comment on effectiveness would require knowledge of a target sales figure If such a target had been less than or equal to $14,900,000, the salespersons could have been considered effective Otherwise, a degree of effectiveness of less than 100% must be assigned The manager of sales expenses may be considered to be slightly more than 100% efficient as evidenced by the $3,000 favorable variance presented in part c (CMA adapted) a Budgetary slack is a planned difference between budgeted revenue and expected revenue and/or budgeted expenditures and expected expenditures Budgetary slack describes the tendency of managers to underestimate revenues and overestimate expenditures during the budgetary process in order to build in allowances for unexpected declines in revenue and/or unforeseen expenses Budgetary slack occurs because of conflicts between a manager's personal interests and the interests of the organization These conflicts include pressure from management to achieve budgets and the desire on the manager's part to look good in the eyes of upper management • • • b (1) From the point of view of the business unit manager, budgetary slack provides Flexibility under unexpected circumstances The opportunity to show consistent performance despite variations in departmental resources and workloads A blending of personal and organizational goals Chapter 15 167 Financial Management (2) From the perspective of corporate management, the use of budgetary slack increases the probability that budgets will be achieved This increased probability facilitates the overall corporate budgeting process Corporate management may also allow budgetary slack as a form of reward to managers for previous good performance From the point of view of corporate management, the use of budgetary slack increases the likelihood of inefficient allocation of scarce corporate resources, decreases the effectiveness of the corporate planning process, and decreases the ability to identify potential weaknesses or trouble spots in the budgetary process and, thus, limits corrective actions c (1) Zero-base budgeting is a planning and budgeting technique that evaluates all proposed operating and administrative expenditures as though they were being initiated for the first time Each manager must evaluate each expenditure, investigate alternative means of conducting each activity, evaluate alternative budget amounts for various levels of service, justify each expenditure, and finally, rank expenditures in order of importance (2) Winston Labs could benefit from zero-base budgeting as each of the business unit managers would be required to specifically identify and justify all proposed expenditures for the upcoming year This increased evaluation of expenditures would make it difficult to include budgetary slack in the budget for the upcoming year (3) The biggest disadvantage of zero-base budgeting is the significant amount of time and cost involved in its implementation Additionally, the concept of zero-base budgeting may be difficult for management to learn and accept Winston Labs must be sure that the benefits of zero-base budgeting outweigh the associated costs (CMA adapted) 168 56 Chapter 15 Financial Management The memo should provide the following information: Although the activity-based budget provides excellent information about the costs of the various activities necessary to fulfill a particular organizational function, these budgets not identify the resources (e.g., salaries, occupancy costs) that are consumed by each activity A resource, or traditional budget, will provide this information To prepare a resource budget, it is necessary to understand the relationship between activities and resources To estimate the cost of specific resources, it is necessary to identify the resources associated with each activity Next, the quantity of each resource consumed by each activity is estimated Finally, using the cost driver of each resource, the cost of resources associated with each activity can be estimated The end product is a resource budget similar to traditional financial budgets 57 Firms accumulate cash for three reasons: to liquidate planned transactions, to provide for liquidation of unplanned transactions and for speculation Internet companies may have greater needs than traditional companies in all three areas Because many Internet companies have operating cycles that consume, rather than produce, cash, these companies must have cash available to cover cycle shortfalls Second, Internet companies operate in a less predictable environment and must maintain cash balances sufficient to cover contingencies Also, the Internet environment is very fluid, and Internet companies must maintain enough cash to exploit unexpected opportunities (e.g., the opportunity to purchase a weak competitor) Finally, the Internet companies may have difficulty acquiring cash from either public or private sources on reasonable terms if the firms are forced to go to capital markets under distress circumstances Chapter 15 Financial Management 169 Cases 58 a Some considerations for the bookstore include: • Exercise prudent cost management over discretionary costs One of the more significant discretionary costs is advertising • Maximize use of technology Although book handling is inherently a labor-intensive exercise, transaction processing related to sales, purchases, and repurchases can be highly automated to save labor costs • Institute programs to reduce employee turnover Because many employees may be students, employee turnover can be very high Employee turnover increases specific costs such as employee training, quality failure costs, and unemployment taxes • Arrange floor space to minimize book handling costs and to facilitate the flow of students • Work closely with professors to ascertain which books will be used in the upcoming semester and which will not be used again • Develop associations with book wholesalers to market books that are no longer adopted by the local university • Encourage professors to adopt the same book for multiple sections of the same class to realize economies of scale in purchasing and shipping • Provide incentives to students to purchase books early so that the work-load can be spread across more time and be handled by fewer employees • Use temporary rather than permanent employees to handle busy season work • Find innovative ways to manage freight costs Examine alternative modes of transportation By ordering earlier, slower and less expensive freight delivery modes can be used • Rent temporary warehouse space to handle the bulge in inventory that accompanies the start and end of school terms 170 b Chapter 15 Financial Management Some considerations for book publishers include: • Maximize the life cycle length of each publication so that fixed costs can be spread across more units • Manage the product mix so that unprofitable publications are eliminated • Manage the number of publications that are overseen by each editor • Adopt labor-saving technology to improve quality and reduce labor costs in the publishing operation • Make professors aware that there are costs to providing teaching supplements and that such costs must eventually be passed on to students • Conduct market research to determine what students and professors desire in terms of textbook features, content, and supplements This will minimize expenditures on unprofitable and low-volume products • Minimize the number of drafts of each book that must be printed prior to printing the final version • Focus quality control on each textbook while it is in draft form to eliminate changes that are very costly to make in later stages of production • Consider the use of part-time editors and other employees • Consider outsourcing those aspects of operations that can be accomplished more efficiently and effectively by outside vendors • Manage the purchasing of paper and other inputs to minimize handling costs and maximize purchase discounts • Concentrate on developing JIT production capability to minimize production of books that are currently not in demand This will reduce storage needs and costs associated with carrying inventory • Adopt the latest technologies in cost management (e.g., activity-based costing) Chapter 15 Financial Management 59 171 c Students can • Share textbooks with a friend or acquaintance who is taking the same class This approach can effectively cut the cost of purchasing books in half • Avoid purchasing supplements and other materials that are not required by the instructor • Purchase their required textbooks from students rather than the bookstore This eliminates the bookstore markup • Purchase the paperback editions rather than hardback textbooks • Sell textbooks to the bookstore or other wholesalers at the end of the semester • Use electronic versions of the textbook rather than paper versions to eliminate publication costs • Exert pressure on professors to eliminate the use of unnecessary supplements d College textbooks are different today for three major reasons First, the subject matter of many disciplines has changed dramatically in the past 20 years Second, the technology available to publishers has advanced and allows more sophisticated products to be developed Third, the market has become extraordinarily competitive and has forced textbook publishers to offer more comprehensive products to attract and maintain market share To: From: Subject: Mary Ross Barry Stein Explanation of November 2003 Variances a The revenue mix variance resulted from a higher proportion of participants being eligible for discounts The budgeted revenue was based on 30 percent of the participants taking the discount; but, during November, 45 percent of those attending the courses received discounts As a result, the weighted average fee dropped from $145.50 to $143.25 b The most significant implication of the revenue mix variance is that the proportion of discount fees has increased by 50 percent If the increase represents a trend, the implications for future profits could be serious as revenues per participant day will decline while costs are likely to remain steady or increase 172 c Chapter 15 Financial Management The revenue timing difference was caused by early registrations for the December program to be held in Cincinnati The early registrations resulted from the combined promotional mailing for both the Chicago and Cincinnati programs These early registrations have been prematurely recognized as revenue during November d The revenue recognition in November of early registrations for the December courses is inappropriate, and, consequently, revenues during the month of December may be lower than expected e The primary cause of the unfavorable total expense variance were additional food charges, course materials, and instructor fees Although these quantity variances are unfavorable, the increased costs of $10,400 are more than offset by the additional revenues of $40,740 with which these items are associated f The favorable food price variance was determined by multiplying the difference between the budgeted and actual price per participant day times the actual participant days The actual price per participant day was determined by dividing the actual food charges by the total participant days ($32,000 ÷ 1,280) g While the combined promotional piece had a $5,000 unfavorable impact on November expenses, there will be no need for further promotion of the Cincinnati program Therefore, the $20,000 budgeted for this purpose in December will not be expended, lowering planned expenses for the month The promotion timing difference represents an incorrect matching of costs and revenue The costs allocated to the Cincinnati program should be reflected on the December statement of operations to be matched against the December program h The course development variance is unfavorable to the November budget, but its overall impact on the company cannot be determined until such time as the level of acceptance of the new course is experienced (CMA adapted) Chapter 15 Financial Management 173 Reality Check 60 a 61 The figure relates directly to activity-based management At the heart of activity-based management is the notion of controlling activities and understanding the relation between activities and cost generation Only through controlling and eliminating non-value-added activities are companies able to achieve improved cost performance b According to the figure, quality is the foundation of cost efficiency and therefore, an important determinant of profitability The figure suggests that high quality is a precursor to high profitability in an organization c The figure suggests that a low-cost/low-quality strategy would be ineffective in achieving profitable operations The implication is that low-quality operations would always be cost inefficient and accordingly would never reach levels of high profitability a The use of part-timers is obviously an effective cost control technique The firm is able to avoid incurring the fringe benefit and other indirect costs associated with full time employees Further, using part-timers allows the firm to expand and contract capacity to avoid the generation of idle resources that are normally found in a seasonal business b If there are qualitative differences between those workers who are willing to work part time and those who are only willing to work full time, these qualitative differences may be impounded in the work they perform However, the quality of the work performed by paraprofessionals should be controllable through careful supervision and careful selection of tasks c It is unlikely that part-timers and paraprofessionals, used in lieu of full time professionals, can enhance the effectiveness of public accounting firms It is much more likely the case that they are hired on the grounds of efficiency The paraprofessionals and part-timers are a less expensive input than full-time professionals to the various service activities conducted in public accounting firms 174 62 a b Chapter 15 Financial Management Effective cost management is not simply reducing costs to the lowest attainable level Costs must be managed in the manner that most effectively implements the strategy of the firm By merely cutting costs, firms can adversely affect important competitive dimensions such as product quality Only if the Chinese-produced crawfish is equal to the Louisiana product in terms of quality and all other dimensions except price is purchasing the Chinese crawfish equivalent to purchasing the Louisiana crawfish In this case, the Chinese crawfish are probably not equivalent to Louisiana crawfish The local consumers expect to be served Louisiana crawfish This expectation exists independent of quality considerations Consequently, informed consumers will avoid purchasing Chinese crawfish and may be willing to pay more to obtain “genuine” Louisiana crawfish Local consumers have a preference for Louisiana crawfish because they prefer to support the crawfish industry in Louisiana rather than in China, and consumers prefer Louisiana crawfish because of the imagery and tradition of that specific dining experience Some circumstances include the following: • Laying off workers in conjunction with the implementation of new production technology • Moving production operations to Third-World countries to avoid high labor costs of the home country • Cutting costs “across the board.” • Outsourcing activities to reduce costs but in so doing sacrificing a potential important core competency • Reducing expenditures on discretionary fixed costs to manage reported income despite potential negative consequences ... c d e f Cost understanding Cost reduction Cost avoidance for the cost of call-forwarding; the increase in costs for staff shows a recognition of client need and services to be provided Cost avoidance... level of awareness and cost consciousness of employees regarding cost understanding and cost avoidance in the travel and entertainment category His remarks display his keen insight and experience... demand This will reduce storage needs and costs associated with carrying inventory • Adopt the latest technologies in cost management (e.g., activity-based costing) Chapter 15 Financial Management