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Summary Lectures Strategic Value Management
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Summary of all Lectures for the course Strategic Value management of the master Accountancy & Control of the University of Amsterdam.
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Lecture Notes Strategic Value ManagementWeek 1 Cost, volume and profit analysis
Management accounting information ( including planning and costing information) serves many
roles:
- To improve decision making: how can we optimize the cost structure? How can we optimize
the profit of the firm? How to increase customer profitability etc. So it is all about cost
structure, cost behavior, product costing, product mix decisions, product pricing and short-
and long-term planning.
- Focuses effort to improve performance: it gives information on where we should improve
performance, for example benchmarking, what is the cost of our product, what is the cost of
our services. It is helpful to evaluate, are we doing the right things to improve performances
in certain areas. We can use this for all kind of issues: service levels, supply chain
management, procurement, lean six sigma etc.
- Guides strategy evaluation and development: for example budgeting tells you where you
want to invest in for the next couple of years in the firm, what the operating budget of sales
should be, if we compare the budget with the actual results which units are underperforming
etc. We use all kind of techniques for this like budgeting, decentralization, transfer pricing,
(non)financial performance management. This part also guides strategy development, what
means the implementation of the strategy we have.
- Evaluates contribution of business units and managers (incentive system): we use
accounting information systems to setup transfer prices, but also to evaluate for example
service level agreements, including (non)financial performance measures. And we use
accounting information to setup compensation systems, for example the profit of a business
unit is the basis for the bonus of an individual manager.
These roles may sometimes conflict, for example incentives may interfere with budgeting practices
which are not in best order for the firm. So the type of roles differs in the individual decision making
situation you may face.
The accounting information which is used generally includes:
- Revenue drivers: any factor that affects revenues.
Simple case: unit of output sold, selling price.
General case: marketing expenditure, customer satisfaction, design product/service.
- Cost drives: any factor that affects cost.
Simple case: unit of output produced.
General case: number of sales visits, orders handled, packages shipped.
- Various time spans for decision.
Simple case: short time span, less than a year.
General case: short run, long run, product life cycle, corporate life cycle.
- Cost/Volume/profit (CVP) analysis: we only look at the number of units sold, sales price and
the number of units produced as they factors to consider.
CVP analysis
Operating profit = total revenue – total cost Q = units sold
Operating profit (OP) = Q * USP – (Q * UVC – FC) USP = unit sales price
UVC = unit variable cost
FC = fixed cost
TOP = target operating profit.
CVP is generally used to figure out what the breakeven point(BEP) is.
,Operating profit = total revenue – total cost = 0
Q * (USP-UVC) -FC =0
Q * (USP-UVC) = FC
Q = FC / (USP-UVC)
(USP-UVC) = unit contribution margin (UCM)
CVP target operating profit: the desired profit we attend to realize.
TOP = total revenues – total costs
TOP = Q * (USP-UVC) – FC
Q * (USP-UVC = TOP + FC
Q = (TOP+FC) / (USP-UVC)
Managers can make decisions to change these numbers, like change in cost structure, for example
increase operating leverage, which will lead to an increase in fixed cost, and a reduce in variable cost.
This decision is more risky if you don’t have any sales, but also has a higher profit if you do sell. So
the variable cost line is less steep, the profit line is steeper and the target profit is realized earlier.
Impact of cost structure: it affects basically the profits that firms can realize, and this means that
firms can act upon this and should manage the activity. CVP is very specific. In general life is much
more complex than CVP suggest, but CVP may give managers an understanding to what is happening
in the firm in case to certain decision being taken. It highlights the risk as well as the potential
reward, and this is what we call operating leverage. For firms with high fixed cost they can use CVP to
give a first inside, but companies may often use other practices like capacity costing in order to
manage fixed cost.
With capacity costing firms are talking about:
- Committee cost: cost associated with committed resources, like personnel costs, IT,
depreciation of PPE. These costs are generally based upon planned level of activities.
- Flexible cost: associated with flexible resources, like raw materials or electricity costs.
- Note that organizations can make trade-offs over time: fixed tenured staff versus flexible
labor.
Total cost function provides total estimated cost for a company:
- Depends upon choice of capacity (structured cost management)
- Depends upon activity level (executional cost management)
Most companies have high levels of committed costs (airlines, hotels etc.), which means that the
margin improves when revenue goes up, and the margin decreases when the revenue goes down.
Cost structures and capacity costing also have indirect (common) costs: which are costs that are
entirely independent of the level of capacity. It does not has anything to do with the operations of
the firm, like Finance, HR or the HQ. these operations are called business sustaining, you need to
have them but they are not effecting the operations.
There are also some resources and costs that vary with the level of capacity. For example
manufacturing facilities that makes it possible to operate your firm, or maintenance which is all
necessary to keep the firm running, and we try to take them in account when looking at the level of
capacity in the operations of the firm.
We are generally interested in the costs of unused capacity, because those costs affect our profit line,
and basically we want to make sure that we use the capacity we have optimally.
To compute costs of unused capacity we say: resources supplied = resources used + unused capacity
,The cost of unused capacity:
- depends upon the choice of capacity (theoretical, practical etc.);
- Average use: number of years we call the normal utilization;
- Customer demands: peaks in demands which we can allocate the cost to certain customers.
- Development and demand patterns over time: actual budgeted utilization. For example you
bought a machine which was used heavily in the beginning, but over time the demands
would go down so the machine will be less used. In this situation we can look at the actual
utilization for the upcoming year and take this into account when we allocated the cost
associated with the unused capacity.
Capacity cost:
- Theoretical capacity: optimal amount of work that asset can complete during full operation.
- Practical capacity: when you take into account the safety margins that you need, for example
you need to take one machine out for maintenance.
- Normal capacity: average, expected utilized capacity of a machine over a defined period of
time (week, month or year).
- Budgeted capacity: planned utilization of asset for the coming year.
- Actual capacity: capacity actually used for period production (utilized machine hours)/
P&L based upon capacity shows the same operating profit, but by separating the capacity cost we
give different signals to the managers. When we look at product profitability, when there is a loss
manager could think to stop with this product because it is not profitable. With a negative operating
profit they would think the product itself is profitable, but we should make more use of the capacity
to make an operating profit.
What can the management do:
- Increase prices: difficult in regulated and/or competitive market;
- Improve capacity utilization: train example increase number of passengers during the
weekend or outside the rush hours;
- Reduce capacity: sell machines or return them to the lease company;
- Reduce idle capacity: improve maintenance schedules or buy more reliable machines.
The idea of capacity costing is to make the excess costs which are attributable to idle capacity visual
for managers. If you make it visual the manager will try to reduce those costs, because they are
based on profit, and if you reduce costs profit increase.
We can report the idle capacity cost separately, but we can also report the non-financial measure.
For example the utilization of assets relative to total capacity. Which can be used as performance
manager to motivate managers.
The cost of idle capacity should be treated as period-cost rather than product related costs. The idea
is that it prevents the ‘death spiral’ where fixed costs are allocated over decreasing amount of
products.
Death spiral means:
- That the overhead costs, including idle capacity, are allocated to products;
- Products are priced high relative to competitors (margins are low);
- Demand is reduced;
Buchheit (2003) Reporting the cost of capacity
, It seems a good idea to separately provide the capacity costs to prevent the death spiral, Buchheit
says that may not always be a good idea. Buchheit looks at if reporting the cost of capacity makes
sense. He suggests firms look at resources they have and try to meet the long-run demand that they
face. The question here is should those capacity costs be explicitly be reported, and if it does so how
does that effect the capacity decision managers make.
Cooper & Kaplan (1992) say you should do it: separate used from unused capacity. With the benefits:
- Information benefit: identifies potential inefficiencies and opportunities;
- It changes behavior due to incentives, by showing that you have excess capacity managers
start reducing the capacity, because it may improve the compensation.
- Prevent death spiral costing (product costs independent of output volume)
- Signaling benefit, explicitly shows emphasized unused capacity, and it is not hidden in other
costs.
The question is why would providing this information be beneficial, because it does not give any new
economic information. It only effect the information that is made visual, but the loss does not
change.
Buchheit is looking at research in psychology and human information processing:
- He says direct presentation of information increases the changes that information will be
used. For example if you directly say this are your cost from used capacity and unused
capacity and this is your total profit as a result, it gives a signal to managers. It shows
managers it is important and that they should manage this.
- Information displays affect decisions in cost-benefit settings. Decision makers may
underweight non-explicit information and may overweight explicit information.
- Asset capacity costing explicitly displays the cost of unused capacity, that will result in
managers managing the capacity. So what he says is if you explicitly make the capacity cost
available that results in lower capacity levels, because managers will start reducing this
capacity.
- Another thing Buchheit is saying is that minimizing unused capacity cost is not necessarily the
same as maximizing the firm value. So rather this information is used by managers, and is
useful for managers depends on the situations which they are in. For example decision
makers often anchor on long-term trendline information and adjust on these trends (vb:
economy is going up or down).
This is called an Anchor-and-adjustment bias, where decision makers generally fail to properly adjust
from this anchor.
H2a) Which means if long-term demands for products trends downwards, explicitly making this
capacity available is beneficial for the firm.
H2b) If the long-term demand is upward, you would get a negative situation wherein you may not
serve your customers in the future and would destroy value for the firm.
Research design:
- Data gathered through an experiment.
- 68 students from 2 universities with a financial incentive
- 2 x2 experiment:
Explicit vs non-explicit reporting of capacity
Increasing vs decreasing demand
Results:
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