Appunti di Management control

Relationship Between Unit Selling Price and Unit Variable Costs

TFCTFCV = UP - UVC (Unit Contribution Margin)

UCM = the portion of sales useful to cover the TFC

Using Break-Even formula, a manager may be also interested in learning a targeted sales level (V) to achieve a targeted profit (T).

In this case, we can calculate the "Targeted Profit (T) and Targeted Sales Volume Level (V)" as:

TT = (UP - UVC) * V - TFC

(UP - UVC) * V = TFC + TT Total + TFC

V = Costs + Target Profit / (UP - UVC) Unit Contribution Margin

*The approach to solving this problem is to treat the Targeted profit (T) as an "added increment of fixed costs".

Accordingly, UCM must cover the TFC and the desired profit (T)

Break-Even analysis: The contribution Margin €400

TFC TFCV = 160 units

B - UVC (UR Unit Contribution Margin €8.50-6)

Profit per Unit Differs at each Volume, while the Unit Contribution

Margin is “constant” for all Volumes.

Def: The Unit Contribution Margin is the Difference between the Unit Selling Price and the Variable Cost per Unit It represents the incremental money generated for each product/unit sold after deducting the variable portion of the TC.

UCM tells how a particular product/service contributes to the overall profit of the company. It provides one way to show the profit potential of a particular product offered by a company and shows the portion of sales useful to cover the company's fixed costs.

Break Even Analysis: The Operating Leverage

The increase in per-unit Profit is caused by the decrease of Unit Cost as the Volume increases.

Note: As Volume increases avg. per-unit Costs “Decreases” because the avg. Fixed Cost of each unit decreases. This phenomenon is described as “Operating Leverage”, namely the loosely as spreading Fixed Costs over a Higher Volume In Eg. the “operating leverage” factor is 5

• Profit goes up 5 times as much as the Volume.
• The contribution Profitgraph(UR – UVC) * V – TFC = I (i.e., Income)
• E.g., €(8.50 – 6.00) * 250 – €400 = €225 → Considering €2.5[unit contribution margin] and €400[TFC] 160 V units must be sold before enough contribution will be earned to cover fixed costs.
• I = (UR – UVC)*V -TFC where the "slope" of the straight is the UCM€ - 400
• The loss at 0 Volume[TFC] Break Even = 160 units
• The Volume at which cash inflows from sales are equal to the related cash outlays from operating costs
• Improving Profit performance I = (UR – UVC) * V – TFC
• Note: The C-V-P diagram is a useful tool to study the basic Profit components of a business.
• A manager could focus on possible 4 strategic decisions to increase Profit:
1. "Increase" Selling Price per unit (UR);
2. "Decrease" Variable Cost per unit (UVC);
3. "Decrease" Total Fixed Costs (TFC);
4. ...

“Increase” Volume.

E.g. • Volume= 200 units;

• UVC = €6 per unit;

• TFC = €400 per period;

• Selling Price = €8.50 per unit.

Focusing on possible 4 strategic decisions to increase Profit, which could be the effect of a 10% variation in each profit-determining factor?

Criticalities

Please, remember that Break-Even Analysis does not consider Market Demand.

Knowing that we need to sell e.g., 500 units to reach the BEP doesn’t tell us if and/or when you can sell those 500 units. Demand elasticity analysis is needed!

In the case of soft demand for a product, it could be needed to change the pricing strategy to enhance the probability to market that product as faster possible.

However, discounted pricing can raise BEP. If a manager is not careful, a product could be marketed faster at a lower price, but the firm will incur increased variable costs to produce more units in order to reach the new BEP.

Moreover, a manager needs to decide how much effort

and time is willing to expand to reach the BEP.

Concluding remarks

The C-V-P diagrams show what total Costs and Revenues are expected to be at various levels of Volume.

However, there are possible many following reasons other than the level of Volume why costs and revenues in one period are different from those in another period:

1. Changing in input Prices (possible "inflation effects" on salaries, material and service costs, etc.);
2. The Rate at which Volume Changes ("adaptation" of productivity capacity transition);
3. The Direction of Change in Volume (possible "lags" in costs, e.g. hiring new workers);
4. The Duration of Change in Volume (temporary changes affect costs less rather than long-term ones);
5. Prior Knowledge of the Change (managers ex-ante informed about changes in volume can play well);
6. Productivity (the C-V-P diagram assumes only a certain level of productivity in the use of resources, as the level of productivity changes the costs changes);

The Management Control Process

How does the MC system work?

Accounting Information used in MC

Phases of MC

Accounting Information in MC

Generally, MC systems account Full Cost data/information to support managers in making program decisions. Differently, in each Budgeting and Measurement processes the accounting information are structured in RCs (namely adopting the Responsibility Accounting mode). Such accounting structure is useful because the Control is exercised only by every RC manager.

To better understand the nature and the use of the Responsibility Accounting Information system we need to know that Costs could be classified as:

1. Controllable or noncontrollable;
2. Engineered, Discretionary or Committed.

"Controllable and noncontrollable Costs"

A Cost could be defined as a "Controllable Cost" if its amount is significantly affected by the

Controllable Costs:

1. Refers to a specific RC;
2. Its controllability results from a significant influence (rather than a complete) produced by the RC manager (e.g., A manager could have a limited influence on its labor costs, but he/she usually could have a significant influence on the amount of labor cost incurred in his/her department, despite the wage rates defined by both the human resources department and the union negotiations).

N.B. Generally, Direct Costs for a RC are controllable (exceptions e.g.: Depretiation, Rental charge), while Indirect Costs for a certain RC are noncontrollable costs.

[Please see other specifications and examples about these issues reported on book (pagg. 685-688)].

"Engineered, Discretionary and Committed Costs"

Another classification of costs useful for the functioning of the MC system identifies:

1. Engineered Costs;
2. Discretionary Costs;
3. Committed Costs.

The Engineered Costs are computed using an analytical process:

The Direct Material Cost is a perfect example.

A standard direct material cost of 1 unit of product = ( ) ¿the quantity of material input needed produce 1 unit of output × the means of a standards price that should be paid per unit of each type of material input

The Discretionary Costs (also called Programmed Costs) are items of costs which could variate inline with the judgment of the manager of a RC (e.g., R&D, Advertising, Public Relations Expenses, Marketing Activities, all Gen. & Adm. Expenses, and many Indirect Production Costs). They could change in time by different decision policies, such as: “spending the same amount as last yr”; “spending a % of the sales”; “spending x amount + a % of sales”.

The Committed Costs (called also Sunk Costs) are those items of costs related to commitments expense previously made (e.g., Assets Depreciation, Insurance, Rent, and...

Taxes). Phases of MCMC system is characterized by Formal and Informal activities. A Formal MC system acquires input from Strategic planning (upstream activity) and it is articulated in the following activities:

• Budgeting;
• Measurement and Reporting
• Evaluation.

An overview of phases of MC

Strategy Formulation

The main purpose of the MC system is to support the management in elaborating and implementing the firm's strategies. The process which identifies, evaluates and decides strategies is called "Strategy Formulation". Each Strategy Formulation is a dynamic process due to changing scenarios (e.g., consumer preferences, new opportunities to capitalize on new technologies, market competition, etc.). Such activity could be processed informally or formally. Most large companies have a "formal system", so-called "Long-range Plan", in which they account for projections about the financial (Revenues, Costs, Profits) and other impacts (e.g., Benefits) of

These programs for several years ahead (2-25 yrs). We could identify such activity simply as "Planning".

Strategic Planning

The "upstream phase", preliminary to activate MC process is the "Strategic Planning" activity, namely:

This process provides inputs to define Programs useful to implement the corporate strategies identifying objectives and allocating the approximate amounts of each resource needed.

The strategic planning process could allow top management in:

1. Reviewing the Ongoing Programs;
2. Considering proposals for New Programs;
3. Coordinating programs defining a formal strategic planning system.

From Strategic Planning to Budgeting

"Ongoing Programs"

The Management is a continuous phenomenon during the time. Most activities processed by a firm during the short-term are often similar to those already in progress.

"If an agri-food company currently produces 20 lines of packaged foods, it probably will handle almost

"All of these lines next year". However, firms operate in a dynamic environment (consumers' needs and taste, competitiveness strategies and production methods could quickly change in time). Therefore, firms need systematically to review each existing program anticipating new changed scenarios and deciding on appropriate actions (e.g., Restructuring or Downsizing Programs to reduce or eliminate Costs). "Ongoing Programs: the Zero-Base Review" "Zero-Base Review" (ZBR) method to analyse Ongoing Programs Every function within an organization is analyzed for its needs and costs. The budgets are then built around what is needed for the upcoming period, regardless of whether each budget is higher or lower than the previous one. The process