COMMERCE COACH
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Friday, August 26, 2011
Thursday, August 25, 2011
Tuesday, August 23, 2011
ACTIVITY BASED COSTING
Activity Accounting with Kohler and Staubus
In the 1930s, the Comptroller of the Tennessee Valley Authority, Eric Kohler developped the concept of Activity Accounting. The Tennessee Valley Authority was engaged in flood control, navigation, hydro-electric power generation, etc. Kohler could not use a traditional managerial accounting system for these kind of operations. Instead Kohler defined activities and introduced activity accountants. An activity is (a portion of) a work carried out by a (part of) a company. For each activity Kohler created an activity account (Aiyathurai, Cooper and Sinha, 1991, PP 61-64). An activity account is an income or expense account containing transactions over which an activity supervisor exercises responsibility and control (Kohler, 1952, pp, 18-19). Thus instead of determining the costs of a product, Kohler determined the costs of an activity.
In 1971 Staubus described another activity accounting system. Staubus also created an account for every activity. On the left side of this account Staubus recorded the costs of the inputs of the activity. These inputs are the outputs from previous activities within the company and / or outputs from another entity (for instance an outside supplier). On the right hand side of the account Staubus recorded the value of the output of the activity. The outputs to another activity are measured at standard costs. If however the output is sold to a customer, the output is measured at the net realizable value (selling price minus selling costs). Staubus activity accounting culminates in a comparison of outputs, at standard cost or net realizable value, and inputs (Staubus, 1971).
Activity Cost Analysis at General Electric
In 1963 General Electric formed a team which had to study indirect costs. This team focused mainly on indirect activities in GE such as data processing, inspection, quality control etc. and determined the costs of these activities. Then they identified the causes of these activities ("key controlling parameters"). For instance a new drawing, made by the engineering department is a key controlling parameter and triggers activities such as data processing, inspection, quality control, etc. The team also collected information about the quantity or count of each key controlling parameter, such as the number of new drawings per period. Then the team estimated the total costs per unit key performance parameter, for instance the costs per 1 new drawing made by the engineering department:
With this technique GE wanted to get better control of indirect costs by controlling the activities that cause the indirect costs (Johnson, 1992, pp 131-141).
Activity Based Costing in the 1980s and 1990s
The activity based costing systems, described by Robin Cooper and Robert Kaplan in the 1980's and 1990's, has attracted much attention. These systems identifies the major activities of a facility's production process and then classifies these activities into one of the following categories:
unit-level activities;
batch-level activities;
product-sustaining level activities and;
facility-sustaining level activities.
The unit-level activities are performed each time a unit of a product is produced. The number of times unit-level activities (such as drilling holes and inspecting every part) are performed varies according to the number of units produced. The batch-level activities are performed each time a batch of goods is produced. The number of times batch-level activities (such as setting up a machine) are performed varies according to the number of batches made. The costs of these activities can be assigned to individual batches but they are fixed regardless of the number of units in the batch. Product-sustaining activities are performed as needed to support the production of each different type of product. Examples of product-sustaining activities are maintaining product specifications, performing engineering change notices and developing special testing routines. These costs can be assigned to individual products but are not proportional to the number of units or batches produced. Facility-sustaining activities support a facility's general manufacturing process. Examples of facility-sustaining activities are lighting and cleaning the facility, facility security and managing the facility.
The costs of the unit-level, batch-level and product-sustaining level activities are attributed to products based on each product's consumption of those activities. The costs of facility-sustaining activities are allocated to products arbitrarly or treated as period costs. In the example below, described by Robin Cooper (1994, pp. B1-20-B1-21);
the number of direct labor hours a product consumes is the cost driver for unit-level activities;
the number of setups a product consumes is the cost driver of batch-level activities;
and the number of parts a product consumes is the cost driver of product-sustaining level activities.
According to Robin Cooper activity based costing systems can be used to monitor how an organization's resources are consumed and helps to manage consumption and spending in a company. With activity based costing systems managers can attempt to perform its activities more efficiently, reprice poducts or alter the company's product mix (Cooper, 1994, pp. B1-9).
In the 1930s, the Comptroller of the Tennessee Valley Authority, Eric Kohler developped the concept of Activity Accounting. The Tennessee Valley Authority was engaged in flood control, navigation, hydro-electric power generation, etc. Kohler could not use a traditional managerial accounting system for these kind of operations. Instead Kohler defined activities and introduced activity accountants. An activity is (a portion of) a work carried out by a (part of) a company. For each activity Kohler created an activity account (Aiyathurai, Cooper and Sinha, 1991, PP 61-64). An activity account is an income or expense account containing transactions over which an activity supervisor exercises responsibility and control (Kohler, 1952, pp, 18-19). Thus instead of determining the costs of a product, Kohler determined the costs of an activity.
In 1971 Staubus described another activity accounting system. Staubus also created an account for every activity. On the left side of this account Staubus recorded the costs of the inputs of the activity. These inputs are the outputs from previous activities within the company and / or outputs from another entity (for instance an outside supplier). On the right hand side of the account Staubus recorded the value of the output of the activity. The outputs to another activity are measured at standard costs. If however the output is sold to a customer, the output is measured at the net realizable value (selling price minus selling costs). Staubus activity accounting culminates in a comparison of outputs, at standard cost or net realizable value, and inputs (Staubus, 1971).
Activity Cost Analysis at General Electric
In 1963 General Electric formed a team which had to study indirect costs. This team focused mainly on indirect activities in GE such as data processing, inspection, quality control etc. and determined the costs of these activities. Then they identified the causes of these activities ("key controlling parameters"). For instance a new drawing, made by the engineering department is a key controlling parameter and triggers activities such as data processing, inspection, quality control, etc. The team also collected information about the quantity or count of each key controlling parameter, such as the number of new drawings per period. Then the team estimated the total costs per unit key performance parameter, for instance the costs per 1 new drawing made by the engineering department:
With this technique GE wanted to get better control of indirect costs by controlling the activities that cause the indirect costs (Johnson, 1992, pp 131-141).
Activity Based Costing in the 1980s and 1990s
The activity based costing systems, described by Robin Cooper and Robert Kaplan in the 1980's and 1990's, has attracted much attention. These systems identifies the major activities of a facility's production process and then classifies these activities into one of the following categories:
unit-level activities;
batch-level activities;
product-sustaining level activities and;
facility-sustaining level activities.
The unit-level activities are performed each time a unit of a product is produced. The number of times unit-level activities (such as drilling holes and inspecting every part) are performed varies according to the number of units produced. The batch-level activities are performed each time a batch of goods is produced. The number of times batch-level activities (such as setting up a machine) are performed varies according to the number of batches made. The costs of these activities can be assigned to individual batches but they are fixed regardless of the number of units in the batch. Product-sustaining activities are performed as needed to support the production of each different type of product. Examples of product-sustaining activities are maintaining product specifications, performing engineering change notices and developing special testing routines. These costs can be assigned to individual products but are not proportional to the number of units or batches produced. Facility-sustaining activities support a facility's general manufacturing process. Examples of facility-sustaining activities are lighting and cleaning the facility, facility security and managing the facility.
The costs of the unit-level, batch-level and product-sustaining level activities are attributed to products based on each product's consumption of those activities. The costs of facility-sustaining activities are allocated to products arbitrarly or treated as period costs. In the example below, described by Robin Cooper (1994, pp. B1-20-B1-21);
the number of direct labor hours a product consumes is the cost driver for unit-level activities;
the number of setups a product consumes is the cost driver of batch-level activities;
and the number of parts a product consumes is the cost driver of product-sustaining level activities.
According to Robin Cooper activity based costing systems can be used to monitor how an organization's resources are consumed and helps to manage consumption and spending in a company. With activity based costing systems managers can attempt to perform its activities more efficiently, reprice poducts or alter the company's product mix (Cooper, 1994, pp. B1-9).
Sunday, August 21, 2011
Balanced Scorecard
Total Quality Management
Many of the Total Quality Management (tqm) concepts originated with the work of Dr. W. Edwards Deming, the American statistician. During World War II he taught American industries how to use statistical methods to improve the quality of military products. After World War II, General MacArthur took 200 scientists and specialists, including Dr. Deming, to Japan to help rebuild the country. Many Japanese manufacturing companies adopted Dr. Deming’s philosophy. Deming’s major philosophy is that quality improvement is achieved through the statistical control of processes and the reduction in variability of these processes. Deming emphasises that management should encourage employee participation and should encourage the employees to use their understanding of the processes and how they can be improved (Munro-Faure and Munro-Faure, 1992, pp 291-292).
Dr. Joseph M. Juran broadened quality from its original statistical origin. He stressed the importance of systems thinking that begins with product designs, prototype testing, proper equipment operations, and accurate process feedback. Juran provided the move from Statistical Process Control to Total Quality Control in Japan. This included company-wide activities and education in quality control, and promotion of quality management principles. By 1968, Kaoru Ishikawa, had outlined the elements of Total Quality Control management:
quality comes first, not short-term profits
the customer comes first, not the producer
customers are the next process with no organizational barriers
decisions are based on facts and data
management is participatory and respectful of all employees
management is driven by cross-functional committees covering product planning, product design, production planning, purchasing, manufacturing, sales, and distribution (Ishikawa, 1985)
The Scorecard at Analog Devices, Inc.
In 1986 Analog Devices, Inc. (ADI), a mid-sized semiconductor company, hired Art Schneiderman as Vice President of Quality and Productivity Improvement. Schneiderman introduced goals for a series of quality measures that correspond to what he considered to be the critical success factors for ADI (Anthony and Govindarajan, 1997). As part of the five-year strategic plan of ADI, Schneiderman also developed a one page report, called the Scorecard. This scorecard showed three categories of measures: financial, new products and Quality Improvement Process:
The basic idea in creating this scorecard was to integrate financial and nonfinancial metrics into a single system in which they did not compete with one another for management airtime (Schneiderman, 2001).
The Balanced Scorecard in the 1990s
In 1990 Bob Kaplan invited Schneiderman to the Nolan-Norton study group on performance measurement. Bob Kaplan and Schneidermann presented the use of the scorecard at Analog Devices, Inc. During a second Nolan-Norton study the participants implemented scorecards within their organiations. Eric Norton, who served as the project leader and facilitator, and Bob Kaplan wrote up the experiences of the participants with the scorecard and devised a "balanced scorecard" in 1992. This balanced scorecard supplemented traditional financial measures with criteria that measured performance from the perspective of customers, internal business processes and innovation and learning. When using the balanced scorecard, companies articulate goals for each perspective and translate these goals into specific measures. An example (Kaplan and Norton, 1992):
In 1996 Kaplan and Norton argued that the balanced scorecard could be used as a strategic management system which supports four management processes (Kaplan and Norton, 1996):
Translating the Vision: Lofty statements such as "becoming the number one supplier" or "best in class" are difficult to translate into operational measures that have meaning to the people at the local level. Creating a balanced scorecard however forces management to further clarify their vision until they are able to translate the vision into a set of objectives and operational measures on the balanced scorecard, which have meaning to the people who have to realize the vision. These objectives and measures for the four perspectives, agreed upon by all executives, describe the long term drivers of succes.
Communicating and Linking: Implementing a strategy begins with communicating the strategy up and down the organization and educating those who have to execute it. The strategy must also be translated into goals and performance measures on the balanced scorecard for operating units and individuals. Rewards might be linked to these performance measures.
Business Planning: Managers set targets for the long term objectives for all four scorecard perspectives. In order to achieve these long term objectives, managers identify the strategic initiatives required and allocate the necessary resources to those initiatives. Finally, managers establish short term goals (milestones) for the measures that mark progress towards achieving the long term objectives.
Feedback and Learning: Managers formulate a strategy based on certain hypotheses about cause-and-effect relationships. Examples of hypotheses:
- a higher customer satisfaction (a measure in the customer perspective) is correlated with faster payments of invoices (a measure in the financial perspective) and faster payments result in a higher return on capital (another measure in the financial perspective) or:
- improved information systems (a measure in the internal business processes perpective) result in higher sales (measure in the financial perspective).
When a company implements the strategy it might found out that certain cause-and-effect relationships are not found over time. In that case a company should reconsider the theory underlying the unit's strategy and might even conclude that it needs a different strategy. This process of gathering feedback, testing the hypotheses on which strategy was based and making the necessary adjustments is called "strategic learning". According to Kaplan and Norton, companies should use the balanced scorecard as the center for management processes, instead of budgets (Kaplan and Norton, 2001 pp. 22-26):
Many of the Total Quality Management (tqm) concepts originated with the work of Dr. W. Edwards Deming, the American statistician. During World War II he taught American industries how to use statistical methods to improve the quality of military products. After World War II, General MacArthur took 200 scientists and specialists, including Dr. Deming, to Japan to help rebuild the country. Many Japanese manufacturing companies adopted Dr. Deming’s philosophy. Deming’s major philosophy is that quality improvement is achieved through the statistical control of processes and the reduction in variability of these processes. Deming emphasises that management should encourage employee participation and should encourage the employees to use their understanding of the processes and how they can be improved (Munro-Faure and Munro-Faure, 1992, pp 291-292).
Dr. Joseph M. Juran broadened quality from its original statistical origin. He stressed the importance of systems thinking that begins with product designs, prototype testing, proper equipment operations, and accurate process feedback. Juran provided the move from Statistical Process Control to Total Quality Control in Japan. This included company-wide activities and education in quality control, and promotion of quality management principles. By 1968, Kaoru Ishikawa, had outlined the elements of Total Quality Control management:
quality comes first, not short-term profits
the customer comes first, not the producer
customers are the next process with no organizational barriers
decisions are based on facts and data
management is participatory and respectful of all employees
management is driven by cross-functional committees covering product planning, product design, production planning, purchasing, manufacturing, sales, and distribution (Ishikawa, 1985)
The Scorecard at Analog Devices, Inc.
In 1986 Analog Devices, Inc. (ADI), a mid-sized semiconductor company, hired Art Schneiderman as Vice President of Quality and Productivity Improvement. Schneiderman introduced goals for a series of quality measures that correspond to what he considered to be the critical success factors for ADI (Anthony and Govindarajan, 1997). As part of the five-year strategic plan of ADI, Schneiderman also developed a one page report, called the Scorecard. This scorecard showed three categories of measures: financial, new products and Quality Improvement Process:
The basic idea in creating this scorecard was to integrate financial and nonfinancial metrics into a single system in which they did not compete with one another for management airtime (Schneiderman, 2001).
The Balanced Scorecard in the 1990s
In 1990 Bob Kaplan invited Schneiderman to the Nolan-Norton study group on performance measurement. Bob Kaplan and Schneidermann presented the use of the scorecard at Analog Devices, Inc. During a second Nolan-Norton study the participants implemented scorecards within their organiations. Eric Norton, who served as the project leader and facilitator, and Bob Kaplan wrote up the experiences of the participants with the scorecard and devised a "balanced scorecard" in 1992. This balanced scorecard supplemented traditional financial measures with criteria that measured performance from the perspective of customers, internal business processes and innovation and learning. When using the balanced scorecard, companies articulate goals for each perspective and translate these goals into specific measures. An example (Kaplan and Norton, 1992):
In 1996 Kaplan and Norton argued that the balanced scorecard could be used as a strategic management system which supports four management processes (Kaplan and Norton, 1996):
Translating the Vision: Lofty statements such as "becoming the number one supplier" or "best in class" are difficult to translate into operational measures that have meaning to the people at the local level. Creating a balanced scorecard however forces management to further clarify their vision until they are able to translate the vision into a set of objectives and operational measures on the balanced scorecard, which have meaning to the people who have to realize the vision. These objectives and measures for the four perspectives, agreed upon by all executives, describe the long term drivers of succes.
Communicating and Linking: Implementing a strategy begins with communicating the strategy up and down the organization and educating those who have to execute it. The strategy must also be translated into goals and performance measures on the balanced scorecard for operating units and individuals. Rewards might be linked to these performance measures.
Business Planning: Managers set targets for the long term objectives for all four scorecard perspectives. In order to achieve these long term objectives, managers identify the strategic initiatives required and allocate the necessary resources to those initiatives. Finally, managers establish short term goals (milestones) for the measures that mark progress towards achieving the long term objectives.
Feedback and Learning: Managers formulate a strategy based on certain hypotheses about cause-and-effect relationships. Examples of hypotheses:
- a higher customer satisfaction (a measure in the customer perspective) is correlated with faster payments of invoices (a measure in the financial perspective) and faster payments result in a higher return on capital (another measure in the financial perspective) or:
- improved information systems (a measure in the internal business processes perpective) result in higher sales (measure in the financial perspective).
When a company implements the strategy it might found out that certain cause-and-effect relationships are not found over time. In that case a company should reconsider the theory underlying the unit's strategy and might even conclude that it needs a different strategy. This process of gathering feedback, testing the hypotheses on which strategy was based and making the necessary adjustments is called "strategic learning". According to Kaplan and Norton, companies should use the balanced scorecard as the center for management processes, instead of budgets (Kaplan and Norton, 2001 pp. 22-26):
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