Topics

In this section I will deal with some issues in a detailed and, at the same time, simple way about the world of controlling, its topics, both strategic and operating ones, both the current approaches and the future trends, that is the way the companies "do it" and are going to do it and, of course, my advice.

 

65. OKRs and their Strategic Use in the Finance Dpt

64. Flexibility in Real Investments, its Financial and Strategic Value

63. When Depreciation Does Make Sense for the Operating Decision Making

62. Variable Costing vs Full Costing for the Profit Center Assessment

61. The New Evolution of the Performance Indicators

60. Management Accountant Profession in the Spotlight - The Last Song

59. Digital Assets and Customer Data: How to Evaluate Them as Fixed Assets

58. How to link the Capital-Investment Decisions to the Strategy

57. A full view on the use of the Value Chain Analysis

56. Labor-Intensive Businesses and the Learning Impact on Cost Estimation

55. Strategic Reporting Adherence: Lean, from the processes to the accounting

54. Zero-Based Budgeting and its Strategic Sides

53. How Many Kinds of Overhead Variance Analysis!

52. Project Control and some Risk Assessment Methodologies

51. When  the Operating Leverage is used as an excuse

50. A Common Manufacturing Accounting "Misundertanding"

49. Make the Right Price.

48. The Choice of the Kind of Bonus: Advantages and Risks

47. How Well is Your Company Using Its Money?

46. ROI: Some Strategic Sides about it and other financial performance metrics

45. Value Creation or Value "Invention"?

44. The Strategic Cost of Quality

43. The Rule of Thumb doesn’t exist

42. Why is the  Healthcare Cost Accounting so peculiar?

41. The strategic sides of Target Costing 

40. The great implications of the true Capacity Costs (PART TWO)

39. Which is the Most Profitable Customer? 

38. The Game of the Ending Inventory

37. How the "work" of the Support dpts affects the Cost Accounting Settings

36. Only Just In Time?

35. The "Way" to spot the real profitability by product

34. Risk Management: some important metrics

33. Another useful "piece" of variance analysis for the BU

32. Budgeting process: not only a numerical issue 

31. The great implications of the true Capacity Costs (PART ONE)

30. How does the Lean Accounting support the decision making?

29. The strategic interpretation of the productivity measurement (PREVIEW)

28. How deep you can dig and some strategic aspects in the variance analysis

27. Strategic distortions in the capital-budgeting project evaluation

26. Some errors in the capital-budgeting analysis

25. How and why to try to understand the real trend of the overheads

24. The cost variance analysis in the project control (INTRODUCTION)

23. The cost management and the customer-driven value model (PREVIEW)

22. What if you compete on timeliness and speed to customers?

21. The Strategic Fixed Overheads

20. The assessment of the State of the Work according to the activities

19. The choice of an appropriate costing system

18. How to deal with the uncertainty in the estimation process

17. The importance of the Product/Service Life Cycle costs

16. Resource Consumption Accounting: a comprehensive management accounting system

15. Strategic Transfer Pricing: Cost-based and Negotiated Price Methods

14. Motivation and other strategic factors in the Transfer Pricing: Market Price

13. Strategic sides of ROI

12. SBU's manager evaluation: - Nonfinancial measures and strategic structure

11. How can you evaluate your business? 

10. How do you deal with the indirect costs? 

9. A very useful "piece" of variance analysis for the BU  

8. Are you getting right about the estimation of the overheads? 

7. Constraints? Here is the way to make decisions 

6. Are you customer-oriented? Here's how you can know about that 

5. Global succes indicator

4. Which kind of standard cost is it convenient to set? 

3. Joint products: how the  contribution margin is calculated  

2. ABC: - Great difference in calculating the financial variances versus the traditional costing systems 

1. The cost of the complexity

 

Have you ever heard of OKRs if never used in your company?

 
If not or just in a broad sense this is the time to write about them and linking them to the Finance function, just how the author wants to do in this article.

First of all a general dissertation on these tools is appropriate and we will deal with it by making use of some comparisons and examples.

A way to understand OKRs is comparing them with MBOs and OKRs and analysing the main differences.
When done it is possible to dissert about OKRs and their strategic use in the finance function.

 

What’s the difference between OKRs and MBOs?

Both are used to achieve some goals within the strategy framework of the business but some specific characteristics make them different.

First of all the definitions.

 

MBO: Management by Objectives

OKR: Objective and Key Results

 

The main difference is that MBOs set what the goals are, while OKRs dig deeper into the process and indicate a set of measures of progress towards the goal achievement.

Another difference concerns the decision level.

 
A a matter of fact MBOs come from Top Management that decides and directs the organization's goals for a 12 month period, while OKRs derives usually also from the bottom and the reference period is the quarter.

What about the addressees!?

MBOs are directed to the single workers/employees, whose bonus is tied to the degree of the objective achievement, while OKRs are intended for teams.

The employee's autonomy is usually larger in MBO set than it is in the OKR frame since what is important is the success in hitting the goal set.

As a result of this, the breakdown is greater in OKRs where its specifications, the Key Results (3/5 for each Objective), are a set of Initiatives monitored weekly.

The degree of achievement difficulty is higher in OKR framework than it is in the MOB one.

 
The Objectives and Key Results are very challenging.

 

We could keep on analysing both measures but we should move the focus of the article that doesn't imply to dig deep into each of them and it's to highlight the strategic role of OKRs into the Finance dpt.

That's why we are going to do the same when recalling KPIs (Key Performance indicators).

 

At this point an example will make the difference perceivable and at this first stage we'll consider just one Key Result within the OKR frame just to highlight the difference.

 

MBO goal for Sales Department:

Increase sales revenue by 20%.

 

OKR goal for Sales Department:

Objective:

 
Increase sales revenue by 30%.

KR 1: Enlarge the market share by decreasing Sales Prices (according to Cost Leadership Strategy, for instance)

As you can see at this first glance the goal in OKR is more ambitious and moreover there is an intermediate and more detailed result (KR 1) throughout the path towards the definitive achievement of the objective.

 
As a matter of fact and as I wrote in the above lines, these intermediate results are usually 3/5 that are field indications of the progress and efficacy of the team involved in the achievment of the target (Objective).

 

We won't stop here since we are aware that the existence of other tools can create confusion.

Another comparison comes into play!

 

KPI vs OKRs

In particular the most appropriate comparison is between KPIs (Key Performance Indicators) and the metrics of OKRs, the 3/5 results derived from the Objective reference of the OKR concerned.

 
Key Performance Indicators are used to evaluate performance over time of an organization.

Usually you can find these indicators within a Balanced scorecard where they are first of all:

 

- Linked to strategic goals.

- Measured against targets.

 

Said in this way no difference emerges between the two figures considering also that both are directed to a department and not to an individual as MBOs are instead and the fact KPIs are usually meausered monthly against the weekly measurements of OKRs doesn't suffice to highlight the distinction.

In my opinion the main point is that OKRs are very challenging while KPIs are difficult but attainable through a mere high commitment of the dpts concerned.

 

You don't see the difference, yet?

 

The example approach is the best one and we'll take into consideration once more the Sales dpt just because the differences are more easily perceivable in this context.

 

OKR for Sales DPT:

 

Objective:

 
Increase in Sales Revenue by 42%

 

Through:

- 1st KR: Improved Retention to 90%

- 2nd KR: 200 New Customers

- 3rd KR: 15% Marketing Lead Increase

 

KPIs for Sales DPT:

- Higher Sales per Rep
- Higher Sales Revenue
- Improved CAC (Customer Acquisition Cost)

As you can see that OKR without a doubt is broken down into more detailed specific actions even when compared to KPIs and that is one of the reasons why it is considered a more challenging stimulous.

 

Haven't I been able to explain the differences amongst MBOs, OKRs and KPIs yet!?

 

Ok, I will try to state these equations:

 

MBOs = Health

 
KPIs = Improvement

OKRs = CHANGE

 

Now we have identified the OKR picture it is possible to move on to the strategic use of this tool in the Finance dept.

 

 

Strategic Use in the Finance Dpt

 

As a matter of fact, Finance Managers can take advantage out of OKRs to achieve the same goals of other dpartments' teams that are transparency about what the finance team is working towards, accountability for the team’s progress towards the results or for the missed results, better internal and external communication and a higher focus on what is most important.

 

Let's pay our attention to the strategy of the business and the usefulness of OKRs in the Finance function that allow to get the right insights on the allignment of the Business actions with its goals.

 

To make this aspect more clear we prefer using the method by example that causes the manager to draw the correct conclusions and decide the potential corrective actions.

 

Let's suppose that a company has a Customer-Oriented approach and focuses its activities on an accurate differentiation of products and services according to the related market segments it addresses.

Of course, the different products and services offered absorbe resources in different quantity and in different quality so that an accurate costing system is needed that may help managers cost correctly the products/services and as a result make a correct pricing based.

 

At this point the Head of Finance decides together with his team to set a specific OKR.

 

The OKR coming into play is this:

Objective: Optimize Cost Accounting System

 

KR 1: Reduce the time to go through with the month-end accounting close by 20%

KR 2: Increase the accuracy of product cost calculations by 30%

KR 3: Set a deeper breakdown of the variance analysis

 

in particular KR n2 in the view of the Head of Finance is crucial since a correct and precise breakdown of the costs incurred for each market segment would increase the quality of the related profitability analysis  and would be a right basis for the decisions to make on each of the market segments (for instance pricing).

Let's guess the accuracy of the costing is achieved or is going to be achieved to the highest degree but according to the latest financial reports the profitability of the whole business has decreased.

The "strange thing" is that Revenues have increased so that the sticking point is represented by the increase in costs.

If KR 2 is achieved but the whole profitability decreases, it means the Strategy of the business isn't being realized successfully and one of the most probable reasons is that the costing system used is inappropriate although the accuracy level has been enhanced to the highest level.

 
In particular the costing method in use erroneously spots some customer as more expensive and some others as "cheaper", obtaining as a result a wrong decision-making basis.

At this point a smart Finance Manager could opt for an Activity-Based Costing approach that would help him solve this specific issue.

 

Some other examples could be made in consideration of the large number of OKRs potentially usable within the Finance dpt but the goal of this article was not to deal with the technicalities of this tool but just making the great strategic role of OKRs clear as much as possible.

Hope to have hit the target.

 

The uncertainty and the risk over the investments in real assets, meaning both tangible and intangible assets, has been dealt with on this page in some articles, but now we want to dig deep into the value of the Flexibility, needed more than ever in these times.

 
Any model based on the Discounted Cash Flow concept is based on the passive acceptance of the results from the decision makers.
In other terms if the outcome (for instance the Net Present value-NPV) is positive then the project is lauched, if not it is rejected.

This Yes-or-No approach doesn't fit well many industries and the current times when the uncertainty and the lack of knowledge about the events analysed and other related info are so high that a dynamic decison model should be very very advisable.

The managers should be allowed to wait for some time to make the decison to kick off the project or to change it about its size or some features or to abandon it.

The model that factors in these options is called Real Options.

A real option is a valuable right to make, modify or abandon some choice that is available to the managers of a business, often concerning business projects or investment opportunities.

It is referred to as “real” because it concerns the projects concerning a tangible asset (such as machinery, land, and buildings.....) or intangible (such a new information system) and not a financial instrument.

The difference between financial options and real options is that the formers, referring to a derivative financial instrument, such as call and put options contracts, have a numerical value in terms of its price or premium one can get on a trading market (exchange), whilst the latters are more subjective and the value they have is not considered into the traditional captital-budgeting decision approaches.

By making use of a combination of experience, and financial valuations, managerst should weigh to a good degree the value of the project involved and whether it's worth the risk.

Real Options can serve as a strategic tool without a doubt and that is one of the goals of this article but first of all the release of some technical explanations is needed to see how it works.

In general we have two ways to incorporate the value of the Real Options when examining some investments/long-term projects; in other words we want to weigh the value of the Flexibility of the choice a manager should face:

- Scenario Analyses and the related decison tree.

- Thee Option-Pricing Models.

 

In the first approach you incorporate the Real Options modelinto a traditional Discount Cash Flow analysis.

The second approach includes different techniques and we will deal with one of the latter methods: the Black-Scholes model.

 

We are going to start from the components of the formula about the price of a financial option in order to translate them into the applications and terms about the the capital budgeting world.

Here it is how a Call option value is calculated, to which we can compare some "real" cases such as the defferal of the start of the investment to a a later date.

The abandonment of project after the first disappointing results can be compared to a Put option, instead.

 

Black-Scholes Formula:

 

C = Se-δt*{N(d1)} - Xe-rt*{N(d2)}

 

 

Where:

C = current call value

S = current stock (or other financial tool) price (also Spot Price)

δ = dividends

t = time until expiration (expressed in years)

N(d1) = the probability that a value in a normal distribution will be less than d

X = strike price of the option

e = 2.71828, the base of the natural logarithm

r = risk-free interest rate

N(d2) = the probability that the option will be in the money by expiration; in other terms the probability that the call option will be exercised on expiry when the S is higher than X

 

Note that e-δt is e to the power of -δt as well as e-rt is e to the power of -rt.

 

Where

d1 = {ln(S/X) + (r-δ+σ2/2)t}/σ*√t

d2 = d1-σ*√t

and

ln = natural logarithm function

σ = uncertainty: standard deviation of the stock’s annualized rate of return (in coninuous compounding)

 

Some requirements/clarifications exist for the Black-Scholes model.

 

Here are some of them:

- The financial instrument does not pay a dividend before expiration.

- There shouldn't be any change in interest rates and variance before expiration.

- Black-Scholes calculates the premium for a call, but also put premium can be calculated by using the socalled put-call parity formula.

- From the Black-Scholes formula, the standard deviation, σ, which measures volatility, can be calculated if the other variables are known.

 

Having said that, what is important is to translate these financial terms into the Real Asset world to make the Black-Scholes (and other Option-Pricing techniques) formula fit for the valuation of the real asset investment.

 

Here are the real-market equivalents of the previous factors:

 

- Spot Price(S) is compared to the present value of cash flows expected from the investment/long-term project on which the option is purchased.

- Exercise price(X) is the present value of all the fixed costs expected over the lifetime of the investment/long-term project.

- Uncertainty(σ) means the unpredictability of future cash flows related to the asset; in other terms it is expressed by the standard deviation of the growth rate of the value of future cash inflows.

- Time to expiry(t) is the duration of the validity of the investment opportunity/long-term project- This will depend on multiple factors such as technology, contracts (licenses, patents, leases) and potential competitive advantage.

- Dividends(d) is the lost value over the duration of the option. This could be the costs incurred to preserve the option (for instance to keeping the opportunity alive), or the cash flows lost to competitors iputting their mony in the investment/the long-term project.

- Risk-free interest rate(r): the yield of a riskless security with the same maturity as the duration of the option. Those flows (Exercise Price) are discounted by a rate that could otherwise be earned for doing nothing.

When exercise price and dividends raise the value of the option goes down.

Instead, increases in spot price, uncertainty, time to expiry, and risk-free interest rate increase it.

 

Example

 
In order to see the importance of the Real Options Model and appreciate the difference with the traditional DCF one an example will be useful.

Because traditional valuation tools such as NPV ignore the value of flexibility, real options are important in strategic and financial analysis. Consider the example of a mining company of copper, which has the opportunity to acquire a five-year license on a block.

When developed, the block is expected to yield 80,000 tons of copper. The current price of a ton from is $ 10,000 and the present value of the development costs is $ 1 billion.

 

The result calculated through a traditonal NPV method is:

 

$800 million - $1billion = -$200 million.

 

According to this valuation the company would leave the opportunity.

 

The uncertainty is not recognized from this valuation tool but as a matter of fact there are at least two factors that mustn't be neglected: the volume and the price of the copper.

Let's guess the company estimates that these two sources of uncertainty jointly yield a 20 percent standard deviation (σ) around the growth rate of the value of operating cash inflows.

The company managers expect to incur the annual fixed costs of keeping the reserve active of $ 20 million (dividend amlount). This represents 4 percent (that is, 20/800) of the value of the asset.

The duration of the option, t, is four years and that the risk-free interest rate, r, is 6 percent.

 

Applying the Black-Scholes model we have:

 

Real Option Value = Se-δt*{N(d1)} - Xe-rt*{N(d2)} =

 = 800e-0.04*4*{(0.58)} - 1.000e-0.06*4*{(0.32)} = +$ 71 million.

 

Note that e-δt is e to the power of -δt as well as e-rt is e to the power of -rt and as a result  e-0,04*4 is e to the power of  -0,04*4 as well as e-0.06*4 is e to the power of -0.06*4.

 

At this point the company may benefit from holding the option up to five years and assess whether and when to exercise it or not, having had on its hand throughout that period new info about that opportunity.

You can notice a $ 271 million difference between the two techniques, but what is it like and where does it come from?

It is the value of the flexibility that the traditional techniques don't take into account.

 

I will be more clear by making another example.

 
Let's take a call financial option on an exchange, available at $ 20 for an exercise price of $ 75 when the stock/financial tool is trading at $ 85.

A buyer who exercised the option immediately would have a payoff of $10 but at the same time he would be loosing $ 5 (that is the option would be out of pocket), since he paid $ 15 for the option

The $ 5 loss is the value of the flexibility of not having to decide whether to make the investment immediately, a flexibility NPV analysis would recognize as zero.

 In our "copper" example: $ 271 million worth is the equivalent of the $ 5.

 

Real Option flaws

 
Real options analysis is still often considered to be "too" heuristic even if based on sound financial criteria.

Some argue that real options recognize the value embodied in the flexibility of choosing among alternatives but their objective values cannot be mathematically determined with an acceptable degree of certainty.

For instance the estimation of the uncertainty is to a certain extent subjective. The base of this estimation is usually the historical volatility/uncertainty but that is not necessarily a very good indicator of how volatility will be in the future.

 

It can represent a reasonable approximation of future volatility where the future is likely to be similar to the past but nowadays the uncertainty about the related events fligh very high and important deviations are possible.

The choice of the quantitative model itself (Binomial, Black-Schole, Lattice model....) used to value a real option is based on judgement of the managers depending on their experience and knowledge.

 

Beyond the Valuation Tool

 

Real Options can be used not only as a good investment valuation tool that higlights and measures the flexibility factor but a strategic instrument that earns money to the company.

 This advantage results just from the fact business managers have that subjective power above mentioned that enables them to use their skills to improve an option’s value before they actually exercise the option.

I will give just one example to make this aspect even more clear.

 

Before doing that you have to take into account that the managers' power is capitalized on by using the those levers that we saw in the previous lines (good for many of the option-pricing techniques).

Here again the levers we are talking about: spot price, uncertainty, time to expiry, risk-free interest, exercise price and dividends.

Our reall example will focus on the lever of the dividends: it is the lost value over the duration of the option. This could be the cost sincurred to preserve the option (for instance to keeping the opportunity alive) or the cash flows lost to competitors investing in the opportunity/long-term project.

In a real case, the cost of waiting of a business is high when a competitor makes the first "move and the first-mover advantages are important.

In this case the dividends are correspondingly high, thus reducing the option value of waiting.

 

What can a manager do to reduce the value lost to competitors?

 

He can "persuade" them not to exercise their option by seizing up the main customers in advance (through for instance marketing actions) of that segment market or lobbying, when this is possible, for regulatory constraints.

 

This is the end of the article and some further analysis of this current and fascinating topic are available if requested on page Contacts.

 

What a headache!

 

- Straight Line Depreciation Method

- Diminishing Balance Method

- Sum of Years’ Digits Method

- Double Declining Balance Method

- Sinking Fund Method

- Annuity Method

- Insurance Policy Method

- Revaluation Method

- Discounted Cash Flow Method

- Depletion Method

- Output Method

- Working Hours Method

- Mileage Method

- Group or Composite Method

- Others

 

Which is the most suitable method for my business to make an appropriate profitability analysis?

 

The issue is remarkable for the tangible assets a business operates during its processes and our dissertation is particularly consistent with this case.

 

Let's start dealing with the issues involved.

 

One should know all the existing methods that may be applied and choose from them or resort to some very qualified consultant able to do it and aware of all the benefits and disadvantages of each of them, not to be neglected.

 

Some argue for instance that Depreciation is a Sunk Cost and as such it is a cost of the past already incurred and capitalized in the Balance Sheet in the first year of its life and as a result no longer to be considered in any profitability analysis and different kinds of decision making in the following reference periods concerning both the whole business unit and the single products/cost objects.

As a matter of fact, according to this view for istance pricing based on a mark-up on the product costs may lead to an extra amount that in the end puts the business out of play in many price-sensitive markets.

 

Nonetheless, although these settings present some good reasons other experts believe that since it's a cost related to long-lived assets, you should know to what extent the operations of the BU "consume" the same fixed assets each year of their life and measure this "consumption" in order to get a reliable profitability standing.

 

This assumption is correct but at the same time a deep knowledge of the different methods of depreciation that enables to measure it as realistically as possible is needed and many of the methods above listed should be excluded and intended only either to the Taxable Income calculation or some other reasons that don't have to do with the profitability aspect and related decision makings.

 

In my opinion a specific method is to be applied in order to have a profitability analysis that can serve as a basis for all the issues involved such as for instance, among others, a reliable performance measurement and assessment of the Business Units concerned as well as a reliable pricing reference.

 

Prior to showing this methodology it would be better make a brief introduction to the matter by explaining just some of these approaches?

 

Let's get started with a "recall" of the reference factors to be considered since involved in the depreciation methods that could be useful to the least conversant people with the subject.

 

These are:

 

- Cost of the asset/historical cost. It is the purchase price of the fixed asset plus further costs incurred to get the asset into working condition.For instance installation cost, freight and transportation and insurance.

 

- Salvage value/residual value known also as the net residual value. It is the net realizable value of an asset at the end of its useful life. It's an estimated value of course.

It consists of of the difference between the sale price and the expenses necessary to dispose of that specific asset.

 

- Estimated Useful Life is the commercial or economic life of an asset.
We mean by that not its physical life but the duration of its effective use to the advantage of the business.

 

Having said that we are going to deal with some of the least known methods, putting aside those very common within the finance people such as the Straight Line Depreciation and Diminishing Balance, in order to let us understand how the objectives underlying this choice are different and how all the reasonings you can make this calculation on are all conventional and predetermined.

All of this jeopardizes the achievement of the best profitability analysis.

 

Sum of Years Digits Method

This method accelerates depreciation with a very fast rate.

The base concept is that an asset when moving towards the end of its useful life produces less benefits than it does in the first periods.

As to the technical aspects, the depreciable amount of an asset is charged to a fraction over different accounting periods.

What do I mean by fraction?

This fraction is the ratio between the remaining estimated useful life of an asset with reference to a given period and sum of the years digits. It turns out that the capital blocked or the benefit coming out of the asset is the highest in the first year.

 

As a result the highest amount of depreciation is allocated in the first year since no amount of capital has been recovered till then.

Conversely, the lowest depreciation amount is charged in the last year as the largest share of capital invested has been recovered.

 

Here is the related Depreciation Formula.  

 

Depreciation = Depreciable Cost x (Remaining useful life of the asset/Sum of Years Digits)

Depreciation = (Cost of asset – Salvage Value) x (Remaining useful life of the asset/Sum of Years Digits)

 

Where:

Sum of years digits = (n(n +1))/2 (where n = useful life of an asset)

 

In my opinion, altough the base prerequisite of this method leading to the highest depreciations in the first years may be accepted, we can easily see how we are dealing with a predetermined measurement regardless of the realistic asset use.

 

Now we will look through briefly, in my opinion, the most tortuous of the accelerated methods due to the adjustments it causes following an overdepreciated asset at the end of its life.

 

Double Declining Balance Method

According to this method depreciation is charged on the value of the fixed asset at the start  of the year, reduced in the years following the first one by the depreciation accumulated.

This is just like the diminishing balance method.

The second step is to apply a fixed rate of depreciation just as we do in case of straight line method but twice as high as that.

This method leads to an overdepreciated asset at the end of its useful life as compared to the anticipated salvage value, so that some adjustments are needed.

 

Like other acceelrated approaches to the Depreciation the Double Declining method is used because suitable for depreciating assets with a higher degree of usage or loss of value earlier in their lives or  for fiscal purposes.

 

What about the "financial" Depreciation methods?

 

Lets's deal with one of them.

Annuity Method of Depreciation

It is commonly used with assets  that have a large purchase price, that are expected to last for many years, such as property or buildings that a company might lease, and to have a fixed (or at least constant) rate of return.

 

On the technical side, the calculation of the rate of return of an asset is needed, just as if it was an investment.

It requires the determination of the internal rate of return (IRR) on the cash inflows and outflows of the asset, so that we can multipliplying it by the initial book value of the asset and the result is subtracted from the cash flow for the period.

That amount is the period depreciation that can be taken.

 

The annuity method assumes that the sum spent on buying an asset is an investment that should be yielding some money.

The concept is that, if the buyer had invested an equal amount elsewhere instead of purchasing that asset, it would have earned some sort of return on it.

 

Depletion Method

Another method that concerns the productive assets and as a result that falls into the product cost calculation is the Depletion one.

It is a specific approach that belongs usually to a particular industry.

Yes we have even some "dedicated" methods and the headache goes on!!

 

It is used for the natural resource extraction industry and it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or aging life of intangibles.

 

Its accounting and financial reporting purposes are intended to accurately identify the value of the assets on the balance sheet and to record expenses in the appropriate time period on the income statement.

 

How does it work?

It is a  sort of use-based methos since when the costs associated with natural resource extraction have been capitalized (the basis fo the depletion), the expenses are allocated across different time periods based upon the resources extracted.

As a result the costs are held on the balance sheet until expense recognition happens.

 

 As to the depletion base, the main factors to cosidere are four:

 

- Acquisition: Costs associated with purchasing or leasing the property rights to land.
- Exploration: Expenses linked to digging under the land that was leased or bought.
- Development: Costs incurred to prepare the land for the extraction of the natural resources.
- Restoration: Expenses to the land to its original condition after completion.

 

We have two ways of applying the Depletion approach:

- Percentage Depletion method.

- Cost Depletion method.

 

The percentage depletion method requires a lot of estimates and it is not based on the effective use recalling the straight line depreciataion method that applies a fixed percentage.

That's why I like to dive deep into the cost depletion method.

 

The cost depletion is calculated by taking the property's basis, total recoverable reserves and number of units sold into account.

The property’s basis (capitalized costs) is spread out among the total number of recoverable units. As natural resources are extracted, they are counted and taken out from the capitalized costs by returning the period depletion (depreciation).

 

For example, the capitalized costs of $2 million yields 10,000 tons of timber.

In the first year, if 2,000 tons of timber are extracted, the depletion expense for the period is $ 400,000 (2,000 tons * ($2,000,000 / 10,000 tons)

 

Some limits are present about this method but it is not the right place where to debate on these but for sure the depletion method under the form of the cost depletion way (not the percentage one) reflects a good approach to give the depreciation procedure a better and more reliable period's profitability index of the assets involved.

 

After showing some of the different methods with the purpose to make it undestood how the choice of a depreciation method good for internal informative requirements and not only for statutory and fiscal aspects is linked to many reasons, I am going to show my favorite in order to get the best decision-making  and assessment basis with regards to the profitability side.

 

My turn

My favorite is a category: the use-based one that takes into account that best driver representative of the real "work" of the asset involved. i

This driver may concern the machine hours, the units manufactured and even the mileage: the choice depends on  the kind of asset involved.

 

Nonetheless, some adjustments in my opinion should be made in order to streamline the significance for the all the decisions based also on the depreciation consideration and that is all the more true in the capital-intensive businesses.

The steps are the folllowing:

 

1) Once the choice abut the most suitable driver is made, at the start of the asset life, the Depreciable Cost (Cost of asset – Salvage Value) has to be divided by the drivers units achievable throughout that life based on a practical capacity "amount".

 

2) At the end of each reference period falling within the asset life, the unit cost per driver we have achieved at the prior point has then to be multiplied by the practical capacity units that we can get or we could have got (depending on you are on an estimate or on an actual) in that single period.

The amount calculated this way is the depreciation amount of that period.

 

3) The latter has to be divided into two components:

 - The share falling into Cost of Goods Sold (Unit Cost per driver multiplied by the driver units worked for the output units sold in the period considered.

 - The share named Unused Asset Capacity that is the difference between the total period depreciation of the point 2 and the share falling into the Cost of Goods Sold.

 

This way of getting the valorization of the Unused Asset Capacity by taking out of the Cost of Goods Sold is important since it allows to measure the inefficiency in the use of the Assets involved and moreover not to charge it to the customers when a cost basis for pricing is used (a way to determine a full valorization of the Unused Capacity and of its elements, when possible,  it is dealt with at n 40 and 31 on this webpage).

Of course when the Asset Useful Life expires, the related depreciation procedure doesn't apply any more.

 

Here is how the Operating Income Statement should be:

 

 Exhibit 1 - Operating Income Statement with the Adapted Use-Based Depreciation 

 

Revenues
Cost of Goods Sold
Gross Profit
Unused Asset Capacity
Sales & Mark.
Admin.
R&D
Operating Income
Invest. Income
EBIT
Interests
Pre-Tax Income
Taxes
Net Income

 

Some further adjustments are possible if we consider that the other accounting items are at the current values while the items concerning the depreciation (accounting item inside the Cost of Goods Sold and the Unused Asset Capacity) are calculated based on the historical cost of the Asset.

When possible we can remedy this mismatch by adopting any kind of revaluation method that updates the value of the depreciation the period considered.

An example could be the Revaluation Depreciation Method I will show hereunder.

 

Revaluation Method

It provides the asset value is assessed at the start of the period considered and at its end.

The resulting difference between them is the depreciation to be charged.

 

To be more precise here is the formula:

 
Asset Depreciation of the period  = (AV)sy + A – D – (AV)ey

Where:

 

(AV)sy = Asset value at the start of the period

 

A = Additions during the period

 

D = Deductions during the period

 

(AV)ey = Asset value at the end of the period

  

At this point the revaluated amount of the period depreciation calculated in this way has to be divided into two components that we get by taking into account the period practical capacity of the asset involved in terms of the driver chosen, just as we have seen in the lines above:

 

 - The share falling into Cost of Goods Sold (Unit Cost per driver multiplied by the driver units worked for the output units sold in the period considered).

 

 - The share named Unused Asset Capacity, that is the difference between the  period depreciation and the share falling into the Cost of Goods Sold.

 

This approach of course presents advantages and disadvantages that won't be shown here and on these reasons I invite you to dive deep as you find it appropriate to do.

Nonetheless, any kind of revaluation of depreciation you will adopt, the resulting Operating Income Statement should contain also the accounting item dedicated to reconciliating te the differences between amount recorded under the Statutory Income Statement and the amount revaluated.

 

Here is the final scheme:

 

Exhibit 2 - Operating Income Statement with the Adapted and Revaluated Use-based Depreciation 

 

Revenues
Cost of Goods Sold
Gross Profit
Unused Asset Capacity
Sales & Mark.
Admin.
R & D
Operating Income
Statutory Reconciliations
Investment Income
EBIT
Interests
Pre-Tax Income
Taxes
Net Income

 

See you soon for the next publication

 

$    (K)	Alfa Inc,	Division Smart TV	Division PC
Revenues	4,000	2,400	1,600
Variable Costs	1,600	1,000	600
Contribution Margin	2,400	1,400	1,000
Controllable Fixed Costs	450	290	160
Controllable Margin	1,950	1,110	840
Noncontrollable Fixed Costs	1,100	700	400
Contribution By Profit Center	850	410	440
Costs at Company Level	300
Operating Income	550

 

The concept we make use of in the above exhibit is the controllabity of costs within one year or less.

In the controllable cost category fall the Variable Costs and some kinds of Fixed Costs such as time indirect labor contracts, research projects, sales promotion, etc.

The rest of Fixed Costs belong to Noncontrollable ones.

The profit resulting by subtracting all these costs from Revenues is the Contribution by Profit Center that is how much the basis is on which one can assess the performances of the Profit Centers in the Short Term (Controllable Margin) and also in the Long Term (Contribution By Profit Center)

 

This Income Statement may even be improved in order to make it more fair how to assess the Profit Center Managers but this will be the core of a future publication.