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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.

 

In these times of great volatility, uncertainty and first of all disruptions in the normal workflow of all the business departments, it becomes clear enough how many of the performace indicators put in place by an organization should enhanced to the upper level.

 

What do we mean by upper level?

 

In order to see the upper level we have to look at the disruptions happening now.

 

The main issues of this period due to the Covid pandemic and the war in Ukraine concern the  highest prices of the materials, of gas and energy, strong delays in the delivery of the same materials, change of the actors throughout the supply chain and last but not least the change  of the businesses to new and most profitable market segments.

As a result all the  projections based on the old indicators, both financial and non-financial, are intended to fail and lack in usefulness for the business.

 

Then the upper level is to be able to assess he responsiveness capability of the organization to the unpredictability, by using new indicators or by combining those already in place in a way that enable the managers to monitor the strength of the respective dpts to respond to the potential changes and to set all the tools needed to stay "afloat.

 

Of course structural improvements concerning the business processes are possible but these have to do with management decisions on the organization that produce their effects in the medium-long term, by setting the business skills to face the potential unpredictability, and that are thought and realized based just on the results of the most appropriate responsiveness indicators.

 

For instance, a good decent process management system, that pays attention to activities that would interrupt the user's work flow or would delay it, would be a good lever of improvement.

Waiting time and other forms of idle time should be spotted and eventually reduced or eliminated or transformed.

 

What do I mean by transformed?

 

If we change point of view waiting time for instance  is a significant indicator of the improvement margin hidden into an organization.

 

That should be seen not just as a kind of waste of the usual tasks but also as an opportunity to carry out new ones and to find solutions.

 

In such a case it can become a business value-added Activity.

 

As to the subject of this dissertation letting the workers do something productive while the workflow is suspended for instance, might also help the business to face even better the extraordinary problems associated with these times.

 

Nonetheless all these "adjustments", and many more, can be done only  if some responsiveness indicators, timely and suitable for their work, are put in place, good for alerting the management on the emerging issues.

 

I am talking about all kinds of indicators, financial and nonfinancial, global and at department level.

 

Let's give an example of financial ones that consists of a comparison of two different components at a defined time interval and of the ratio between them.

 

Financial Reaction Speed

 

Total Contribution Margin Variance/ Total Variable Cost Variance in a given time interval yields an important indication about the financial value of the reaction speed of a business in these troubled times disrupted by hyperinflation and change in the actors of the supply chain.

 

This indicator weighs the capacity of the business to be profitable and gives it the chance to monitor the value of its choices even in the short term.

 

 An indicator even more timely for the manufacturing company  is the same ratio with the Throughput Margin.

 

Throughput Margin Variance/ Direct Material Cost Variance

 

This indicator may be relevant with reference both  to the total amount and to the amounts concerning just the single products.

 

As a matter of fact the Variable Overheads are counted in their actual amount at the end of an accounting period and the respective close procedures while the direct materials and their associated costs are recorded and attributed to their objects "immediately" when they are consumed and this makes the alarm of the throughput use in the ratio most timely.

 

As we now the financial results are the measurement of a process already accomplished while other elements may reveal in advance some issues before they take on a financial value.

 

We are talking about of the nonfinancial indicators.

 

Nonfinancial indicators are becoming more and more important with reference to all the business' departments when facing the emerging continuous disruptions just as it's happening today.

 

Moreover new KPIs or new combinations of the existing ones should be found in order be able to face the problems and meet the customers' needs in a timely manner and more effectively than the competitors do.

 

Having said that, we won't list the ratios or other indicators dpt by dpt since they could be different, depending on the industry and company.

It would be very advisable to find them within a firm trough the work of multidisciplinary teams where the c-suite people work together with the different functions in order to get what is most appropriate.

 

How many times I hear of CFOs accepting the proposal of a Costing software without interacting with a skilled Management Accountant!!

The attention is focused just on the speed of reporting and the easiness of the respective procedures together with the number of reports.

No one considering the fact the appropriatness of those reports may be lacking!!!

 

Since this time is not the first, but it will be the last one, I try to exhamine this root cause for every kind of judjement error, I will make a shortlist of the factors to be taken into account when choosing a costing system that even the best software vendor cannot "impose"

 

a) Job Costing, Process Costing, Operation Costing.

b) Standard, Normal, Actual.

c) Volume-Based, Activity-Based.

d) Business Rate, Department Rate.

e) Theoretical, Practical, Normal, Budgeted Capacity-Based method.

f) Empirical, Heuristic, Mixed leading approach

 

Having seen that, a short focus on every of these elements is needed and in the end it should be clear enough how the choice of a costing system should be shared with the "best" of the business management accountants that combines skills with technical knowledge and familiarity with business processes.

 

a) Lets'get started with the cost gathering method that leads to the distinction among Job Costing, Process Costing, Operation Costing.

 

Let's suppose the Outputs of your processes are very distinguishable from each other in a sense that they can vary in value and features according to the kind and the amount of resources employed for the make of the product or the delivery of the service.

In this case all the costs incurred (Direct materials, Direct Labor and Overhead Costs) may be assigned to  a specific product/service, order, batche of products and project.

In other words Job Costing is the cost gathering system to be used.

 

Instead, if you work at a mass production company whose products are very similar and homogeneous so that they requires similar processes and consumptions of resources, the most appropriate system is without a doubt the Process Costing that first of all "pays attention" to the costs incurred in the processes into the departments and at a second step determines the product/service unit cost.

 

It is not over!

 

When just one category of costs, usually the direct materials, may be varying from one output unit to another whilst the others are similar in type and amount, then we may use the Operation Costing.

 

What I just described would suffice to make it clear how the Management Accountant should be involved in making such a decision but for the most skeptical I want to make my dissertation go all the way!!

 

b) The kind of measurement impacts also the choice of the costing system and leads to the distinction of Actual, Standard and Normal Costing.

The first provides the costing of the specific objects by taking into account the real costs incurred throughout the reference period (Overheads are generally known only at its end).

When some sort of urgency is present in the information needs of the firm, just as it happens in many cases for  the pricing, that moreover cannot be subject to recurrent monthly fluctuations due to the change in the Unit Fixed Costs caused by the variation in Monthly Output volume, the management can opt for the Normal Costing that attributes a predetermined Overhead amount to each product unit based on a predetermined rate while assigning the actual amount of the other cost elements (direct materials in primis). 

This approach is very appropriate of when the strategy is based on the Cost leadership in a very dynamic and competitive environment  where the costs of some elements (direct materials) are fluctuating and at the same time the timeliness of the pricing is a critical succes factor.

 

We go through this distinction by citing the Standard Costing adopted when first of all a sort of homogeneousity is present in all the bisiness processes over time, due for instance to a low customization, and it's possible standardize the product/service costs in all the elements considered without waiting for the costing at end of the accounting period to have a reliable determination.

 

c) The Overhead Costs are attributed to the cost objects by taking into account the most reliable driver whose change in the quantity employed determines a specific variation in the Overhead amount.

When this driver expresses the amount of the Output (usually Labor Hours, Machine Hours) the method is called Volume-Based; when it is the result from each of the different "indirect" activities carried out per cost object (product, service, customer...), we have an Activity-Based approach.

It goes without saying that when the business processes are homogeneous, that many times means to have similar products, kinds of customers, projects, the Volume-Based approach fits well that work environment; in the opposite case when the indirect activities and the resources needed to carry them out differ in nature since the products/services/projects/customers are rather different, the Activity-Based approach is the best possible method.

The literature about ABC is rich and I won't focus on its operating way since the goal of this article is highlighting the general skills of a management accountant and the need for his partecipation in some decision making as a partner and not  just as an executor.

 

d) Another important issue concerning the similarity or the difference of the processes calls for the comparison amongst the work done in the business deparments that should bring about a diverse way to determine the Overhead Allocation Rate when using the Normal Costing or also the Standard Costing at the time of the Overhead Variance Analysis.

 

In order to be more clear, here is an example with reference to a Normal Costing System based on a Volume-Based approach.

 

We may apply two methods to allocate the Overhead Costs to a Product in case of multiple departments inside a firm:

 

1) General Allocation

 

Total Budget Overheads = $ 8,000,000

Budget Overheads Dpt A: $ 2,700,000

Budget Overheads Dpt B: $ 2,400,000

Budget Overheads Dpt C: $ 2,900,000

 

 

Total Budget Labor Hours (allocation driver):  192,000

Budget Labour Hours for Dpt A: 72,000

Budget Labour Hours for Dpt B: 55,000

Budget Labour Hours for Dpt C: 65,000

 

 

Hourly Overhead rate: 8,000,000/192,000 = $ 41,66

 

Let's suppose that the Actual Labor Hours for the Product A are the following:

 

Total Actual Labour Hours: 2,200

Actual Labor Hours on Prod. A for Dpt A: 1,000

Actual Labor Hours on Prord. A for Dpt B: 700

Actual Labor Hours on Prod. A for Dpt C: 500

 

 

Overheads Allocated to Prod. A = 41,666 X 2,200 = $ 91,665

 

1) Specific Allocation/Single Departments

 

Here is the second Overhead allocation way to Product A by taking into account the Input values above written.

 

Hourly Overhead rate per Dpt

Hourly Overhead rate Dpt A: $2,700,000/72,000 = $ 37.5

Hourly Overhead rate Dpt B: $ 2,400,000/55,000 = $ 43.64

Hourly Overhead rate Dpt C: $ 2,900,000/ 65,000 = $ 44.61

 

Overheads Allocated to Prod. A from each Dpt 

From Dpt A = $ 37.5 x Actual LB Hrs Dpt A = $ 37.5 X 1,000 = $ 37,500

From Dpt B = $ 37.5 x Actual LB Hrs Dpt B = $ 43.64 X 700 = $ 30,548

From Dpt C = $ 37.5 x Actual LB Hrs Dpt C = $ 44.61 X 500 = $ 22,305

 

Overheads Allocated to Prod. A = $ 90,353

 

As we can see there is a difference being worth $ 1,312.

 

In this case we might judge it as not material and prefer to apply the General Allocation method more easy and immediate to achieve but when dpt processes are so different so that may absorb different resource quantities and kind of resources (in some cases managers refer to different cost drivers), the most natural choice is to apply different dpt rates in order to have the product costing as accurate as possible.

 

e) Another issue is the choice of the basis to which spread the Fixed Overheads in order to achieve the respective Fixed Overhead Allocation Rate to apply to each object and getting its costing.

As we saw in the articles dedicated to the Output Capacity of a business unit, the solutions are four:

Theoretical, Practical, Normal and Budgeted Capacity.

 

The definitions of these kinds are well-known and I won't repeat them here, inviting you to read the above mentioned articles on this webpage.

It's clear that the Unit Cost resulting from this choice decreases when shifting from Theoretical up to Budgeted or Normal Capacity (usually Average Budgeted Capacity over 3 years).

The consequences from it impact the Product-pricing decisions as well as the performance evaluation aspects.

 

 

f)  The last aspect I want to take into account is the leading approach that causes the business managers to make a decision about a favorite costing system.

 

I am talking about the importance level attributed to the empirical research (if known) that is the findings of the researches made on the accuracy of a costing system, by taking advantage also out of statistical techniques.

 

If we choose to adopt an empirical approach for instance, we will find that the researches show that Volume-Based might work when resource costs are concentrated and that ABC systems are likely to have the greatest benefit when resource costs are diversified. 

Another finding is that when forming pools of costs (each pool with one cost driver different from the other pools) in order to achieve an Overhead Allocation Rate, a low number of cost pools seems to be reasonable because ther is an acceptable tradeoff between the costs of adding more pools and benefits of system accuracy.

 

Other findings have been made but I won't list them in accordance with the purpose of this article I repeat once more: highlighting how the strategic  partecipation of a skilled management accountant to the choice and to the settings of a costing system is "compulsory" and not only advisable.