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Introduction

 

One of the main references to measure the operational and financial improvement of the business units is for sure the productivity.

We have been watching any sort of endeavours by managers to measure all the existing ratios concerning the productivity and comparing them to any kind of of benchmark: past ratios, standard ratios, industry ratios.

I want to raise some questions.

Do these measures have an absolute meaning for the achievement of the profitability of the business?

Does  their impact have a long-term horizon?

Before to go into the answers to these questions and other strategic issues, it’d  better deal with the traditional concepts of the productivity.>>>>>>>>>

 

1. Limitations of the productivity ratios

 

The improvement of these measures both with reference to past ratios and with reference to standard or industry ones, is the natural goal of the management of any business.

In terms easy to be understood, it means a better profitability, the other business factors,  beinq equal, since an equal effort (the input unit)has produced a higher output either in physical units or in sales value, depending on the kind of ratio you are watching.

Nonetheless some considerations should be made.

 

Let’s start with the Partial ratios.

 

Example:

Year 2017

Output units for 2017: 70,000

Direct Labour Hours: 20,000

Cost per L hour: $ 40.00

Price: $ 100.00

 

Year 2018 >>>>>>>

>>>>>>>>>> Another option is a new higher level of the salaries resulting from a new collective labour agreement (with a potential decrease in the Financial ratio) and, then, the increase in the operational productivity is really the consequence of the learning curve or some innovation in the work processes.

These solutions just indicated are some examples that are intended to make clear that the productivity ratios should be interpreted all together whilst the single observation of one partial ratio is very limiting and not important to see whether any productivity strategy of the firm is working.

Very useful is quantifying in financial terms the variance due to>>>>>>>>>>

 

2. Potential evolution of the productivity measurement

 

Nowadays the weight of the indirect costs has grown so that most expenses incurred belong to that category and that happens  in almost every industry.

Nonetheless, the productivity measurement is limited to those inputs that have a clear relation between their consumption and the output achieved and make the monitoring of the productivity easier and immediate.

As a result, all the ratios we know focus their attention on the direct and variable costs, excluding at the same time the>>>>>>>>>

 

3. And what about the long term?

 

What we have seen so far, that is the concept of productivity depending on the concept of variability of the inputs with reference to the output lays its foundation on the length of the time considered.

In fact, when we talk about variable inputs/costs and we are aware of main theories of the management control, it will be easy to recall that only in the short term the separation between variable costs and fixed (asset-related) ones makes sense.

That happens because in the long term all the expenses are>>>>>>>>>

 

 

There are cases when the variance analysis is not effective in the most genuine sense.

I mean that the expenses related to the investigations of the causes of the fluctuations could be higher than the resulting benefits and that the indications out of the variance analysis could be ineffective.

Let’s start with the first case.

 

A) Expensive or not

Thanks to the standard variance analysis you get to know whether and to what extent something has gone wrong compared to the estimate.

At this point every manager wants to act in order to investigate the causes, in particular when the resulting variances are negative in order to take the appropriate corrective actions.

A question arises: what if the search for the causes of those variances is “expensive”?

To answer this question we should point out that there are two categories of the differences to be investigated:

 

1) Systematic Variances

2) Random Variances

 

1) Systematic Variances

 

That's the case when the managers acknowledge the process is steadily causing some unpredicted results that are out of control.

In this category there are two courses of action, that is, investigating o not.

If you decide not to investigate the present value of the costs resulting from the ongoing events the business will keep on suffering is indicated with PL (Present Losses).

If you decide to investigate, the cost of this course of action is indicated with D (Do) and the cost of the correction is C.

The correction comprises not only the cost of the mere corrective action but also the losses the business will suffer until it is made.

 

2) Random Variances

 

When the managers state that the process concerning the variance is in control, the fluctuation should be considered Random, result of the causes beyond the influence of the managers.

Under this category if you decide not to investigate, there won’t be any further cost the business will keep on incurring and the total cost will be 0, because there won’t be investigation activities, corrections and any other damaging events.

If you decide to investigate, the respective cost is indicated with D (Do).

 

After making this distinction, let's examine the advised procedure.

 

If you want to calculate the expected cost of both courses of action (investigating or not) a probability percentage must be attributed to each of the categories (systematic variances and random ones).

We indicate with p the probability of the systematic fluctuations and with 1-p that attributable to the random variances.

Cost of investigation = p x (D+C) + (1-p) x D

Cost of not investigating = p x (PL) + (1-p) x 0

 

At this point a question arises.

To what extent is advantageous for the business to investigate?

Until the likelihood of the courses of action is equal.

 

Solving the 2° degree equation above written, we’ll have:

 

p = D/ (PL – C)

 

For instance, if p is 6%, it means that the business will have the advantage to make an investigation, when the probability of the systematic variances is beyond 6%.

When it is lower, the best solution is not investigating.

 

What I have written until now is good for both revenue variance analysis and for cost one.

The power of affecting the factors of the fluctuations or not and the classification of them as random or systematic concern both revenues and expenses.

 

B) Diverting variance analysis

 

An example is better than many words

 

Input

 

Budgeted Fixed Industrial Overheads for January 2019: $ 140,000

Allocation basis to the products: Machine hours

Budgeted Machine hours: 4,300

Standard Mach. Hours per unit: 3,91

Standard Fixed Industrial Overhead Cost per Mach. Hour: $ 32.56 (because 140,000/4,300)

Actual Output: 920

 

 

Let’s calculate the Fixed Industrial Overhead Production Volume Variance

 

Product. Volume Variance =  Budgeted Spending - Standard Fixed Industrial Overheads applied to production

Product. Volume Variance = 140,000 – (Act Output x Standar Mach Hours per Unit x Mach. Hour fixed industrial overhead cost)

Product. Volume Variance = 140,000 – (920 x 3.91 x $ 32.56) = 140,000 – 117,125 =  22,875

 

As a result of this calculation, we see the Industrial fixed Industrial Overheads are uderapplied (unfavourable indication).

The main input data relevant to the following interpretation is the number of Mach. Hours taken into consideration.

If those hours are the ones needed to manufacture the number of units requested in the budget period from the customers, there will be some diverting effects if the budgeted machine hours are lower than the practical capacity of the plant.

 

In fact, the used capacity is hidden from the view of the managers and this fact could erroneously lead to increase the investment for new plant, machinery and other capacity-related resources in case of estimated increase in the demand for the products or new projects that would need additional work.

Then the best solution to have a full visibility of the utilization of the fixed assets is, when the standards must be decided, to set the budget allocation basis on the number that express the potential use of those assets regardless of the  estimated number requested to meet the market demand in the next period-

This way the Fixed Industrial Overhead Production Volume Variance would have the unused capacity (if he hours used are lower than the available ones)and its cost emerged  and lead the managers to better use the capacity available for projected increase in the production without resorting to new investments.

 

Guess that practical capacity is 4,700 Mach. Hours

 

Then

 

Standard Fixed Industrial Overhead Cost per Mach. Hour: $29.78 (because 140,000/ 4,700)

 

And

 

Product. Volume Variance =  Budgeted Spending - Standard Fixed Industrial Overheads applied to production

Product. Volume Variance = 140,000 – (Act Output x Standar Mach Hours per Unit x Mach. Hour fixed industrial overhead cost)

Product. Volume Variance = 140,000 – (920 x 3.91 x $ 29.79) = 140,000 – 107161=  $ 32,839

 

I want to try to explain even better this equation: $ 140,000 (Available Capacity) – $ 107,161 (Used Capacity) =

= $ 32,839 (Unused Capacity).

 

These considerations are good both for Volume-Based cost-accounting systems and for Activity-Based ones

 

In the latter case the complexity of the respective calculations is higher in the start-up stage but once it is implemented, the results are more accurate.

 

 

C) Ineffectiveness of the variance analysis

 

You know that in setting the standards and later on analysing the standard variance for the variable overheads of any kind (administrative, commercial, industrial) you use some volume-based driver or activity-based driver (if activity-based costing is used) to which the fluctuations of those expenses are supposed to be linked.

As a result, you will have the standard/actual variable overhead cost per machine hour, per labor hour, per set up and so on, as the reference terms to calculate the spending variance and the efficiency variance.

For cost-control purposes, there could be the risk of making the indications stemming from the respective variance analysis ineffective.

That may happen when the person in charge of a specific category of overheads isn’t able to manoeuvre the chosen cost drivers.

For instance, if the cost driver is the labour hours and the person responsible for the overhead fluctuations cannot affect anything of the labour hours, it goes without saying that the potential corrective actions he might take would be partially useless.

As a consequence, the overheads won’t be in control and there would be a further negative result: the person whose performance are assessed on the basis of the overheads will be unmotivated just because he knows of the limitation of his scope.

You need to choose the manager in charge of the fluctuations of the cost driver as the person responsible of the linked overheads.

 

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The methods used to assess wheter a capital investment is good or not are several and each of them has its own advantages and disadvantages.

These features are often looked through under the technical profile and finance managers make their choice from the methods on the basis of their competence and/or the availability of the data needed for applying them.

For instance, we know the Net Present Value together with the IRR (internal Rate of Return) are the most objective criteria to understand if the project is good or not as a whole, considering all the life of it.

The same NPV method encounters some "trouble" when the capital is rationed (this case is largely dealt with from the related literature and in any case it isn't the subject of this dissertation).

Some argue that the IRR don't consider the hypothetic reinvestment of the intermediate cash inflows and resort to the MIRR (Modified Internal Rate of Return).

Both of them, IRR and MIRR, come across important problems when the cash flows are predicted to alternate, changing continuosly (positive and negative) their sign over the period considered, generating as a result multiple values of IRR and MIRR

The Payback model, in its turn, is the most simple since it gives an immediate perception of the breakeven period, but it doesn’t take into account the whole life of the project and can mislead the managers when it comes to choosing the best from alternative proposals.

One can also adopt all the necessary precautions to make the analysis even more reliable and complete, such as explained in the article n. 26 on this webpage, but we are telling of technical issues and not of the strategic sides.

A good manager entrusted with this financial assessment should consider all the cause-and-effects relationships between strategy and methods in use.

In many case I have observed some distortions, that are, strategic decision making in an opposite direction of the goals of the business

Let’s start to examine three different cases.

Of course, I’ll limit the dissertation to the most recurring ones, while in the business life other debatable behaviours can take place.

 

1) Lack of information.

 

Whether you are pursuing a long-term objective or a medium-term one, you need some information on which resting your decisions.

An example will clarify this concept.

You are a manufacturer of mobile phones and are thinking to market a new revolutionary software that could spread the use of objects through the use of the same mobile phones.

This step would be a step in the differentiation strategy compared to the competitors

The new technology should require a huge amount of money invested into Development expenses  and in the specific Advertising, but the managers are not sure whether the market is ready to welcome the new technology.

They realize to need more market information and reliable future macroeconomic data about the areas where marketing these revolutionary mobile phones.

The solution is one out of two, the first listed below is the “Strategic Distortion”:

 

a)  The finance manager wants to make a decision by analysing the investment proposal without taking into account the reliability of the information.

With the help of the marketing dept. he spots three scenarios concerning the demand for new product, attributing  (as the best risk management procedures teach) to the occurring of each of them a percent likelihood.

Then, he proceeds to the analysis of the investment (in the following example, the NPV technique is used).

 

Input:

 

Discount rate (WACC) 12 %

Investment period: 3 years

Investment outlay at period 0: $ 2,000,000

Annual after-taxes net cash inflows per scenario (for simplicity, the same amount in each year):

- Pessimistic: $ 100,000

- Normal:  $ 912,000

- Optimistic: $ 1,400,000

 

Scenario percent likelihood:

- 25% Pessimistic

- 50% Normal

- 25% Optimistic

 

Table 1

WACC 12%	Year 0	Year 1	Year 2	Year 3	NPV	Weighted NPV
Scenarios
25%	(2,000,000)	100,000	100,000	100,000	(1,759,800)	(439,950)
50%	(2,000,000)	912,000	912,000	912,000	190,624	95,312
25%	(2,000,000)	1,400,000	1,400,000	1,400,000	1,362,800	340,700
Average NPV						(3,488)

* The after tax cash flows are considered net of the inflation, as well as the Discount Rate. I remember the relation at issue: Nominal Discount Rate = Real Discount Rate x Estimated Inflation Rate

 

The result of the investment analysis of Table 1 is negative since the Average NPV is - 3,488 and, in view of the unreliable information, considering also   the risk through this sensitivity analysis, it shouldn’t be undertaken.

 

b) The uncertainty about this percent scenario likelihood is too high because the information about the consumer demand is believed to be vague, then a potential deferral of one year of the investment comes up.

This way you aren’t calculating the risk, but even you are trying to “dominate it”

In this case, the procedure should give value to the lapse of time you decide to wait for in order to have more reliable information on which resting your decision to make the investment or not at a deferred time.

This method is called in many ways; I like to name it “the waiting option value”.

First of all, you must exclude that scenario that at the time of decision (in this case year 1) gives a negative NPV, since you’ll make the investment at Year 1 only if the new information at that time about the demand for the new product is good ad as a result the NPV is more likely to be positive.

Taking the previous example, the cash flows must be always discounted for four years but from Year 4 to Year 1.

The same investment outlay of $ 2,000,000 must be discounted for 1 period, from Year 1 to Year 0. We make it at the risk free rate, for instance  4%, since we assume that the amount of it will be always $ 2,000,000.

 

Table 2

WACC 12%	Year 0	Year 1	Year 2	Year 3	Year 4	NPV	Weighted NPV
Scenarios
25%
50%		(2,000,000)	912,000	912,000	912,000	31,328	15,664
25%		(2,000,000)	1,400,000	1,400,000	1,400,000	1,077,760	269,400
Aver. NPV							285,064

 

The projected result is $  285,064, positive and not negative like that related to an immediate investment.

As a result, the manager should wait for another year, when further information about the consumer demand should be more reliable and make the decision of investing or not.

The solution b is the most advisable since it would avoid the distortion of the first one, that is, a decision made without the needed information.

 

2) Conflict between investment criteria and performance evaluation.

 

This situation occurs when the managers of a profit center are evaluated on the basis of criteria that could lead them to accept some investment or reject them  when the same project should have rejected in the former case or accepted in the latter one when examined through an impartial technical criterion.

For instance, if on the basis of a Discounted Cash Flow method the purchase of new machinery that enables the increase in the production of a given model was advantageous, and the performance evaluation criterion was the increase of the ROI of that business unit, its managers could reject the investment when the implicit ROI of the capital investment is lower than the ROI target of the whole profit center.

What happens is due to a contradiction of goals, more strong in some cases, for instance:

a) If the investment assessment method is a DCF, the higher the discount rate the greater the strategic distortion.

b) In case of long life of the investment and the most part of the returns are focused in the last part of it.

c) When the Manager is due to go away (on any reasons) from the business unit as the person in charge of it

The most advisable solution consists of adopting a new criterion in assessing the performance of the managers, achieving as a result a congruent behaviour of them with the interest of the BU.

For any details on these solution, get in touch with www.thestrategiccontroller.com

 

3) The most recurrent strategic distortion is the following and also the most avoidable

 

The firm puts on the table its strategy to achieve its goals in the long term.

Whichever strategy is, price leadership one or differentiation one, the top managers predict its success in the long term.

In this situation the capital-budjeting proposal assessment techniques that take into account just a part of the life of the investment are to be rejected.

The strategic distortion is, for instance, making use of the Payback period that, looking at breakeven period, neglects what happens after that and could prefer, in a potential choice from alternative proposals, the investment more advantageous in the short term but not with regard to the whole life of it.

The solution is easy to be found, that goes without saying.......

 

 

When analysing the way the finance people make their decision processes about the evaluation of the capital investment projects, I observed some important kinds of error or negligence.

That happens regardless of the model used. Either discounted cash flow models or non-dcf ones, the errors happen in the same extent.

When I write about DCF models I mean in particular the IRR (internal rate of return) and the NPV (the net present value).

By Non-DCF models I mean the Payback Period model and the ARR (Accounting Rate of Return).

The points at issue aren’t the suitability or not of each model for a specific capital investment project; that’s why I’ll examine just those recurring errors and not each model listed above.

What are these errors?

 

1) Negligence of some expenses to incur at the end of project

 

You know that the steps an investment project is broken into are three: start period, operating and end one.

We’ll deal with the last step.

For instance, you are evaluating the chance of purchasing a machine for your furniture manufacturing facility dedicated to the computer-driven cutting phase.

After taking into account all the cash flows related to the revenues and costs springing from the previous periods (start one and operating one), you put to your attention the collection, net of taxes, from the sale of the same machine.

Have you forgotten something?

In my opinion yes, you have.

In many cases, the shift of the people dedicated to that machine disposed of at end period involves some sort of emerging outlays, such as retraining, relocation expenses and in the worst scenarios the severance ones.

These costs cannot be neglected, in particular when the people involved are in a great number, and as a result, the  related cash flows are to be taken into exam.

 

2) Opportunity costs

 

The concept underlying this figure of costs requires the existence of an alternative yielding some receipts to the option you are analysing.

In some cases, the attention of the analyst focuses only on the cash flows coming out of the investments under exam and not on the receipts the exisisting alternative can generate.

I am not talking about the analyses of two or more projects intended to meet the same requirements from the company but about the remaining option that exclude the “direction” of the same projects.

An example will clear any doubt.

You are analysing two investment proposals about the building of a warehouse on a land owned by your companyBoth of them give a positive Net Present Value (let’s take this method as that used from the CFO) at the end of a five-year plan: Project A with a NPV of $ 780,000 and Project B with a NPV of $ 610,000.

They seem to have a good result, but someone suggests the CFO to take into account also the alternative to both of the building projects of selling the land.

The potential revenue (opportunity cost), net of taxes and cash-generating one, of this solution is  $ 700,000, making only the project A positive and the best solution amongst the three alternatives.

 

3) Inflation neglected

 

The cash flows for every piece of the period considered are gross of the inflation rate and that is an error when you are analysing a multi-year investment proposal because of the fluctuating value of the currency meant as purchase power of each unit of it.

These corrections must be made regardless of the method applied to the analysis.

It doesn’t matter whether you are using a DCF technique on a Non-DCF one.

 

4) Overheads not included or erroneously calculated

 

When deciding which costs one should think of in order to determine the cash flows of the proposal, some general expenses not clearly tied to it are taken out of the capital-budgeting analysis or calculated in a wrong way.

That happens because of two reasons

A) This category of expenses are believed to be fixed for the sake of simplicity or very hard to link proportionally to the variations of output/processes brought about by the new investment.

B) When they are considered variable costs and affected by the new investment the CFOs/Controllers link them to mistaken drivers and as a result the related cash flows put into the analysis are wrong.

At this point you might make use of some statistical techniques to find the right drivers to which linking the trend of the overheads and understand if the new projects determine a differential amount of them to be taken into account into the analysis.

 

5) Risk neglected

 

When the uncertainty of the future scenarios is present, the analyst must make use of the appropriate techniques to get the most likely cash flows.

For this purpose I remind you also of the previous dissertation published on www.thestrategiccontroller.com “How to deal with the uncertainty in the estimation process” (page Topics, n° 18), where some tips are made.

 

After the points highlighted so far, a question arises.

What about the strategy within this context?

The smart controller/CFO shouldn’t limit  the analysis of the investment proposal to the typical financial side of the matter, but include also the adherence of the investment to the strategy.

For instance, if the project involved a new product to be marketed, you should include the after-sales costs in a right and congruent amount, when considered variable.

I mean that if you choose a machine enabling to manufacture a high volume of output and as a result a lower fixed unit cost of the product to the disadvantage of a higher quality, you should take into consideration a fair amount of warranty costs and other kind of after-sales expenses.

This amount is seen as acceptable or not depending on your strategy.

Given an equal volume of cash flows (gross of this category of costs), if price leadership strategy the acceptable threshold is higher than that if differentiation strategy, because in the latter case a loss of sales and market share could result following the brand-name damage.

The solution is to quantify these costs through an accurate estimate work through the appropriate techniques.

The point at issue is even more important when you are comparing two or more projects/proposals and if you aren’t able to quantify these costs, the solution is to apply a qualitative approach that compares the subject proposals with reference both to the financial side and to the strategy aspect and make the best choice.

The ways you can do this are not my favourite because either they don’t consider the weight to attribute to each side of the analyses or the weight is arbitrary.