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.

 

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

 

This article wants to pay homage to the Project Control and the role the Risk assessment plays therein.

The uncertainty is a typical issue of any business decision to be made but it takes even more importance when the projects take time and the technical steps as well as the related resources may be impacted by the occurence of some events, both positive and negative ones.

That's why any firm operating on project must be well-shelled against the Risk of these events and its operating "way" is so peculiar.

 
The steps a company makes in analysing the risks related to a potential project and are 4: 

 

1. Risk Identification.

2. Assessment

3. Planning

4. Monitoring

 

We are going to deal with the Assessment step, focusing on two ways that can be followed in order to weigh the consequences of some events if and when they occur.

The existing approches are generally categorized into qualitative and quantitative ones, each of them is broken down in different methodologies.

We want to pay attention to one method per approach.

 

Prior to getting started let's give a short definition of the quantitative and qualitative techniques.

 

The quantitative method weighs the risks by means of given measurement units and it is used for different purposes ranging from the financial consequence assessment to the determination of the success probability of the project without forgetting the determination of the effects of potential forced changes in the work schedule.

 

The qualitative approach is intended to rank the total risk of the project without resorting to any unit of measurement, by defining the criteria enabling the assessment of the consequences resulting from the occurrence of the risky events.

 

That said, let's start with a methodology of the qualitative approach.

 

Let's guess a matrix where the projects are classified and ranked according to their positioning with reference to the extent (the higher, the greater extent) of the consequencies of a particular event and the occurence probability of the same event (the more on the right, the less probable the risky event).

 

Matrix 1 - Risk Exposure Matrix

	Occurrence Probability
Extent	a
		b
	c
		d	e	f

 

The projects d, e and f are positioned beyond an Attention Threshold that causes the project manager to pay more attention to these than to a, b and c.

 

The size of this Matrix depends on the levels (number of columns and rows) spotted as appropriated in order to assess the projects according to the usual features of the company projects with reference to some criteria such as:

1. Internal features of the project: skills requested and available, technologies requested, characteristichs of the materials and timing of the supply,....).

2. Financial dimension of the project: presence of subcontracts and/or partners, entity of the investments to be made...).

3. Category of the project: importance of the client, impact on the whole business, contract clauses,...).

 

As you can notice the ranking of the project under the qualitative approach is subjective since it depends on the judjment of the project manager that relies on his ability and the experience of the business about  similar projects that are never the same with reference to the features above exemplified.

On the opposite side the ranking is rather fast and easily comprehensible through that matrix.

 

If you want to be more detailed and professionally appropriate about the definition of the level of the risk, Exposure, for that event you are looking over, you have to spot some categories the risk level falls in and that depends on the combination of the degrees of each variable.

 

Here are the levels of the risk (Exposure) that we suppose are four:

 

1. Absent

2. Moderate

3. Outstanding

4. Alarming

 

At the same time, turning back to our example of the Matrix 1, the variables, whose classification convergengy determine the level of the risk (Absent, Moderate, High, Alarming) are weighed this way:

 

Extent:

1. Irrelevant

2. Reasonable

3. Strong

4. Disastrous

 

Occurrence Probability:

1. Low

2. Average

3. High

4. Very High

 

After that here is the Risk Exposure Matrix in its detailed configuration.

 

Matrix 2- Risk Exposure Matrix (Full Version)

 

PROBABILITY   EXTENT	Very High	High	Average	Low
Disastrous	Alarming	Alarming	Outstanding	Moderate
Strong	Alarming	Outstanding	Outstanding	Moderate
Reasonable	Outstanding	Moderate	Moderate	Absent
Irrelevant	Moderate	Moderate	Absent	Absent

 

 

Once you place your project into one of the Matrix cells its exposure will be immediately ranked and if it lies in the Alarming/Outstanding cells (above an imaginary Attention Threshold Line), it will need all the precautions and consideration of the project manager and his team with reference to that given event under "investigation".

 

If many risky event may occur, as many Risky Exposure Matrixes should be drawn and the classifification of the business projects with reference to the whole exposure comes out as a anatural consequence according to the number of the most risky placements of each project.

 

There is the chance of getting a most accurate classification but that means passing to an intermediate form between quantitative and qualitative approach; nonetheless that isn't the goal of this article and if you want to know more, you can reach to thestrategiccontroller.com on page Contacts.

 

Having dealt with that specic qualitative technique, let's move on to one of the quantitative ones.

The Earnings Matrix is one of the application of the Decision Theory and is particularly useful when assigning a percent probability to a very unusual or even Unprecedented event to assess the Risk Exposure of a project/decision is hard. 

As a matter of fact this is a very current recurring issue and it turns out to be a  very useful way to estimate according to your strategy and your risk aversion.

When the attribution of a percentage to a given scenario/event yhe Bayes' Theory shows up as the best technique we know.

It has previously been "dealt with" in the article n. 18 of this page, "How to deal with the uncertainty in the estimation process", under the paragraph Scenario Analysis.

 

Now let's turn our attention to the Earnings Matrix and draw a matrix where Dx is a specific decision (comparable to a project) and Sy is the state (comparable to an event) you come across when that decision/event comes true.

The combinations of Dx and Sy result in an amount that can be either a gain or a loss and we indicate as P (when negative - P)

 

An example will make the concept more clear.

 

D1 = Launch of a busines product into a single new country

D2 = Launch of a business product into two new countries

D3 = Increasing the sales of the existing products through a larger commercial network in the usual market.

 

 

S1 = Scenario with some Entry barriers into one country.

S2 = Scenario with some Entry barriers into two countries.

S3 = No Entry Barriers into the countries involved. 

 

Matrix 3 - The Earnings Matrix

 

State Decision	S1	S2	S3
D1	140,000	140,000	200,000
D2	220,000	155,000	280,000
D3	200,000	200,000	200,000

 

At this point you can apply your personal Risk Aversion by adopting one of these criteria:

 

Optimistic Criterion: you will choose the decision that realizes the highest potential earnings (in our case D2 with the P (profit) of 280,000 under the Column "S3").

Minimax Criterion: you will choose the decision when the lowest earnigs are the highest possible (in our case D3).

Halfway Criterion: you will choose the decision when the average earnings are the highest possible (in our case D2 with the average is worth 218,000).

 

 See you on the n. 53.

 

We all know the considerations the managers should make when planning their costs based on the concept of the Operating Leverage.

Operating Leverage: Fixed costs/Total Costs

 

Once we have recalled that it is the ratio between Fixed Costs and Total Costs of a business the practical result from this magical formula is that

the higher it is the higher the potential Operating Profit, the higher the potential Loss (if the Sales Units are lower than the Break Even Point).

 

Another ratio we are used to taking into account is the Degree of the Operating Leverage.

 

DOL = Contribution Margin/Operating Profit

 

Let's make an example to explain this concept.

 

Sales Units: 3,000 

Contribution Margin: $ 120,000

Operating Profit: $  30,000

 

DOL = 120,000/30,000 = 4

 

What does it mean?

 

That means that (when everything else is constant: Fixed Costs, Total Costs) each increase in the Sales of 1% would bring about a 4 % increase in the Operating Profit.

It goes without saying the higher the Fixed Costs portion the higher is the potential increase in the Operating Profit.

Why?

Because the denominator will decrease if the fixed costs increase and as a result the DOL will be higher.

 

In some cases you come across the strange thing the Fixed Costs planned are higher than the level some could expect based on the prospects of the market demand.

In some other other cases throughout the Budget period  you may have witnessed the persistence of some Business Units' managers, justified for instance by a need for a technology upgrade, in asking during the resource negotiation process for a high level of investment in Long-lived assets (as a matter of fact mainly Fixed costs)  compared to the level of the Variable costs even if the projections of the Sales Units aren't very good.

 

Be aware that the Operating Leverage and the related DOL, that when high promise great results if the planned Sales are higher than the Break Even Point, can be a good excuse for this persistence.

 

Let's make a distinction.

 

When the company has a great competitive advantage (of any kind) over the competitors, no doubt about that behaviour is needed.

For instance, if your company produces a sort of "unique and advanced" exciter that goes into the airbags of the automobiles, no further "doubt" is needed.

As a matter of fact the safety standards concerning the cars are increasing and increasing over the years and that will make the need for the Airbags constant.

As a result the planned Sales Units of that exciter are not only a plan but an "actual".

 

Instead the doubt will arise in all the cases the responsibility of the Fixed Costs are held under the sphere of the whole Company and the managers of some Cost Centers will be held accountable only for the Variable Costs that are considered controllable by them.

 

In this context when the certainty degree of the customer demand for your products is not so optimistic, the persistence of some Managers towards an exagerated amount of Fixer Costs compared to the total costs of the company should be investigated.

What is this case called?

 

Cost Shifting

 

Some remedies are possible and don't consist just in putting the Fixed assets under the responsibility of the Cost Centers Managers

In fact some nonfinancial indicators to assess the performance of the cost centers involved could be used (I invite you to take a look at the article n. 12, SBU manager evaluation: - Nonfinancial measures and strategic structure,  of this webpage).

In case of Share Assets (those used by more than a single cost center) appropriate cost drivers for the fair allocation the fixed costs to the differnt centers are very advisable.

 

In any case an in-depth analysis of the investment requests will be always an appropriate way of proceeding.

 

At this time I will make just a clarification about a common "operational" misunderstanding just as the strategic side of the controlling dissertations must rely on the correct accounting concepts in order to be fully understood.

Starting from the next article the strategy is going to be predominant again.

 

When many, even managers, talk about the costs of the manufacturing departments, often two different categories are confused with each other.

The Cost of Goods Manufactured and the Manufacturing Costs.

Then, in order to make the things more clear I want to dedicate this article just to this "clarification", leaving the strategical side of the dissertations on this websde aside on this occasion.

 

As a matter of fact, when the confusion reigns, any kind of debate may be useless and that's why I want to make an example of a Manufacturing Statement.

Prior to dealing with it let's take a step back.

 

Here is a piece of an Income Statement of a Manufacturing company

 

Table 1 - Cost of Goods Sold Breakdown

 

Beginning Finished Goods Inventory	$    45,000  +
Cost of Goods Manufactured	$  220,000 =
Cost of Goods Available for Sale	$   265,000  -
Ending Finished Goods Inventory	$     42,000 =
Cost of Goods Sold	$   223,000

 

 

As you can see from table 1, the category of Cost of Goods Manufactured (COGM) is the total amount of Manufacturing dpt expenses that shows up in an Income Statement and that's why, may be, many confuse them with the Manufacturing Costs.

As a matter of fact the COGM includes the Manufacturing Costs and consists also of the Fluctuations concerning the Goods In Process Inventory.

 

What better example than a Manufacturing Statement to distinguish them!

 

 

 Table 2 - Manufacturing Statement

 

Direct Materials
Beginning Raw Materials	$   14,000 +
Raw Materials Purchases	$   92,000 =
Raw Materials available for use	$ 106,000  -
Ending Finished Inventory	$   11,000 =
Direct Materials Used	$  95,000 +
Direct Labor	$  75,000 +
Factory Overheads   indirect Labor $    13,000 + Repairs  $      4,500 + Utilities $    10,100 + Indirect Materials $      2,200 + Property Taxes - Factory Building  $      4,500 + Depreciation - Factory Equipment  $      6,500 + Depreciation . Factory Building $      3,800 = ....................    ...................   ....................
Total Factory Overheads	$  43,800 =
TOTAL MANUFACTURING COSTS	$ 213,80O
	+

 

Beginning Goods In Process Inventory	$    14,200 =
Cost of Goods In Process	$  228,200  -
Ending Goods In  Process Inventory	$      8,000 =
COST OF GOODS MANUFACTURED	$   220,000

 

The strategical side in the next number, again.....

 

One of the most complicated tasks that a business has to carry out is to determine the winning price in order to hit the the desired level of profitability.

 

Why is it so complicated?

 

The answer to this question is the great range of factors to be included in this important decision.

I make a try to do a list so that you may understand the reasons why I make this statement.

 

Here is my attempt:

 

- Gathering the best product/service cost basis.

- Regrouping and channeling the cost data of the point 1 to the product /service unit to reflect the real consumption of the business resources as best as it can and according to the kind of the internal activities and their level of diversification.

- Taking into account the profitability target set by the business top management.

- Taking into account the strategy "chosen" by the top management to build a competitive advantage in the market, if it is based either on the differentiation or on the Price leadership or on a mix of the previous ones.

- Segmenting the customers according to their respective preferences towards the features/functionalities of the product/service amd their purchasing power.

- Considering the product configuration to see whether differentiating the service level of the product/service and applying the following different prices.

- Being adherent to the stage of the Life Cycle of the product/service (launch, growth, maturity, decline).

- Competitiveness level and price of the competitors.

- Seasonality of the demand.

- Inventory level

-------

 

This is the list of the main factors that come up to my mind and that one should consider in setting the right price, sometimes simultaneously.

The extent of the dissertation doesn't aim at comprising all of them but is intended to highlight, just as in all the articles posted on page Topics, the strategic side of the pricing that shouldn't be an automatic task to fulfill.

That's why the issues dealt with here will be just some of those concerned and if you want to know more, don't hesitate to get in touch on page Cpontacts of this website.

It goes without saying that the following content doesn't apply to the most part of the businesses making use of the Target Costing (see article n. 47 on page Topics) that are price takers and not price makers.

 

Let's start with spotting the different situations that a price maker should face with reference to the stage of the product/service Sales Life Cycle.

 

The first step is the Launch (or Introduction) of the product/service and the cost basis for determining the price has to include the R&D costs, and other marketing costs needed to "introducing" it in addition to the "manufacturing" ones (meaning by these the typical costs incurred to deliver the services if the the industry is the service one)  that in their turn, in case of a manufacturing company, consist also of the new production assets to make the new product.

As a result, usually it is the stage when the price the highest of the all Life Cycle.

 

The second step is the Growth and the price is initially rather stable because the demand is high and that allows the business to realize the largest profits in all the life Cycle. The competion gets stronger and the differentiation feature is not as before so at a some point the price will begin to fall

 

The third step concerns the Maturity stage when the demand increases a a lowest rate because the product is not longer something new in the market.

The cost basis should be the manufacturing costs plus the usual marketing/sales ones incurred  and if the business increases the level and the range of the services  (such as the after-sales service) and in some industry tries to enlarge the product functionalities, in order to keep the market share as untouched as possible, the related costs have to be added to the Price basis.

As a result, in consideration of the lowest value acknowledged to the product by the customers, the price falls even more and profit from that product is smaller and smaller.

 

The fourth step is the decline of the sales of the product and of the money the customer are open to spend for it decreases.

The focus of the business shifts to the control and reduction of the macnufacturing and distribution costs. It cannot leverage properly the price to be profitable.

 

If you have paid attention to what happens throughout the Sales Life Cycle, there is a clear decrease from the highest beginning price  related to the differentiation strategy (generally speaking) of the the first two steps to the lowest one related to the cost leadership of the maturity and decline steps.

As a result, this fact changes the cost basis for making the right price that shouldn't be always at the same level for the product/service and the solution is without any doubt a full Life-Cycle Costing method that wouldn't focus only on the Manufacturing dpt but would take into account all the value chain costs attributable to the product/service.

It goes without saying tha in case of a multiproduct business a correct overheads allocation "policy" should be adopted in consideration of the different Sales Life Cycle stage where each of the products is at a given point of the business life.

 

However this falls beyond the scope of the article and cannot be argued here.

 

Turning back to my statement about the appropriateness of a Full Life-Cycle Costing method, do you want an example that may include also a Profit target of a company?

 

Here it is. 

 

Let's suppose that a business estimates for the future period 20,000 Sales unit and want its ROI to add up to 15% of its  Assets, being worth $ 5,000,000.

The Unit Full Life-Cycle Cost is $ 200.

 

First of all, let's calculate the markup needed to hit 15% ROI target.

 

Markup = Assets X 15% / Unit FLCC X Expected Sales =

= 5,000,000 X 15%/ 200 X 20,000 = 18,75%

 

Then the Sales Price.

 

Price = Unit FLCC X (1 + markup) = 200 X (1,1875) = $ 237,50

 

 

Of course this price target is at a first stage an ideal one since the factors that can modify it are several and of different nature.

 

One of this elements that is consistent with the goals of the dissertations of thestrategiccontroller.com is first of all the Strategy adopted by the business to achieve a competitive advantage in its industry compared to the other competitors.

 

This "pararaph" goes beyond the natural and gradual shifts of strategy we have seen in the previous lines when writing about the Sales Life-Cycle of the product/service and it refers to the "will" of the top management to characterize their company.

 

As we have seen my time the choice is from a Cost Leadership Strategy and a Differentiation One except for some market segments where a mixed Strategy is the most appropriate.

 

Let's deal with about the classical two categories.

 

As to the industries where the Cost Leadership is pursued by their actors the Pricing is characterized by the continuos search of the lowest cost basis to which apply the markup and generally the most efficient business determines the price target of the other competitors.

 

More complex is the Price issue in the Differentiation industries where the Strategies policies are different.

The companies involved for instance can resort to a value profiling of their customer segments, spotting the features of their products/services preferred by the customers the most and channelling their expenses to those activities and resources needed to meet those preferences.

The amount resulting from this efforts are the cost basis to which applying a markup.

 

Just as an example of value profiling, here is a table showing the two segments of a pen manufacturer and the value features "weighted" by the customers

 

Table 1 -  Value Profiling of a business customers

 

Value features	Writing pen customers	High-end pen customers	Weighted Average Value
Writing Quality	55%	30%	50.2%
Model Availability	15%	10%	14.0%
Brand Name	9%	20%	11.1%
Appearance	7%	28%	11.1%
Price	14%	12%	13.6%
Total	50,000 (100%)	12,000(100%)	100%

 

Another alternative in the hands of a differentiated firm is the Skimming policy, that is applying (when possible) different prices to the same product/service according to the customer kind; the highest ones to those customer categories open to spend more and the lowest one to those paying much attention to the money spent on the purchase.

 

How to do it?

 

One way for instance is the different level of potential additional services related to the product/services that could be high for the "rich" and lower for the others.

 

Another way is the different timing of the sale: low prices for the first buyers and higher prices for the following.

 

As you can understand the elements for the best price go beyond the simple cost basis and concern factors depending on the will of the top managenet as well as external factors that affect the pricing and cannot be manoeuvred by the managers such as in some industries the oil price, the interest rates, the seasonality of demand...

The purpose of the dissertation was to highlight the strategic side of the pricing and hope to have been successfull.

Of course some further argumentations are possible and that's why the page Contact can't wait for your "initiatives".